Noisy currency movements reflect the future of emerging markets & their economic fundamentals
First the eurotisation and then the strengthening of emerging market
currencies cast a fatal attack on the hegemony of dollar. The economic fundamentals of the emerging markets (EMs) were robust enough to take on the challenges and what the world witnessed was a rally of the currencies of these nations. This phenomenon has come a full circle; the five year rally is coming to an end. Thanks to the ‘monster’ termed inflation; the respective central governments are struggling to combat it. As a matter of fact, inflation in 19 out of the 26 emerging markets now exceeds its tolerance zone. The global economic slowdown is bound to impact economies that are less well positioned or underpinned by fundamentals. “Is it the beginning of currency crises in the emerging economies?” It is a pertinent question that needs to be debated. Keeping aside the self-fulfilling prophecies, the looming currency crisis can nevertheless be prevented by subtle policy changes.
The prediction of the beginning of currency crises is linked to the availability of timely and accurate information about economic fundamentals. Theoretically speaking, weak economic fundamentals coupled with herd behaviour increase the probability of a crisis. Nouriel Roubini in his paper “The role of large players in currency crises” emphasises on the fact that the presence of agents with market power can increase a country’s vulnerability to a crisis and make other investors more aggressive in their position-taking. A fact justified a few years back when global investors became increasingly nervous about holding an overweight US dollar position and opted to diversify their position. This shift in investor confidence added to volatility and weakened the dollar against other currencies. The reverse is happening now; it is expected that the EM currencies will further weaken against the dollar. According to a Merrill Lynch survey, for the first time since 2001, investors prefer US equities over developing economies stock markets.
Turkey’s current-account deficit of a whopping $50 billion by the year end (Moody’s Investor) will see to it that there is a reversal in the Lira–Dollar trends. Analysts are of the view that the Lira, which has appreciated by 10% against the dollar (y-o-y) will fall by approximately 12%. Owing to the large and persistent deficits, South Africa will largely have to depend on foreign capital. The Indian Rupee, which advanced to 12.7% last year, is currently under pressure to weaken further, courtesy the losses in the stock market (since the beginning of the year the market has lost 28.32%), which have raised concerns about capital outflow. The road ahead will be more challenging for the emerging economies as they are bound to witness less of portfolio flows, courtesy the differentiation and the ratings cuts (Fitch Ratings has cut the credit outlook on South Africa and India). Stephen Jen, Chief Currency Economist, Morgan Stanley cites various reasons as to why the South Korean Won (KRW) would also be weaker. According to Jen, “In contrast to most of Asia, Korea does not have energy subsidies. Thus, we expect to see the impact of high oil prices becoming visible in Korea before it does in other countries. The size of the negative ToT shock impinging on Korea is as large as any country in Asia. As a result, the KRW should not be strong.” Globally, as growth decelerates, and as focus shifts from inflation fighting to GDP protection, it is expected that the ratio of US dollar to that of emerging market currencies will gradually drift higher.
The emerging markets today are more concerned about future inflation and consequently a tighter monetary policy; as a result their currencies are selling more aggressively thereby sharply increasing the risk aversion. As far as policy interventions in the emerging markets are concerned, they need to be understood that merely seeking to limit currency fluctuations could end up in fostering more instability. Indisputably, currency movements tend to be oft noisy but in the long term they are a reflection of economic fundamentals.
First the eurotisation and then the strengthening of emerging market
currencies cast a fatal attack on the hegemony of dollar. The economic fundamentals of the emerging markets (EMs) were robust enough to take on the challenges and what the world witnessed was a rally of the currencies of these nations. This phenomenon has come a full circle; the five year rally is coming to an end. Thanks to the ‘monster’ termed inflation; the respective central governments are struggling to combat it. As a matter of fact, inflation in 19 out of the 26 emerging markets now exceeds its tolerance zone. The global economic slowdown is bound to impact economies that are less well positioned or underpinned by fundamentals. “Is it the beginning of currency crises in the emerging economies?” It is a pertinent question that needs to be debated. Keeping aside the self-fulfilling prophecies, the looming currency crisis can nevertheless be prevented by subtle policy changes.The prediction of the beginning of currency crises is linked to the availability of timely and accurate information about economic fundamentals. Theoretically speaking, weak economic fundamentals coupled with herd behaviour increase the probability of a crisis. Nouriel Roubini in his paper “The role of large players in currency crises” emphasises on the fact that the presence of agents with market power can increase a country’s vulnerability to a crisis and make other investors more aggressive in their position-taking. A fact justified a few years back when global investors became increasingly nervous about holding an overweight US dollar position and opted to diversify their position. This shift in investor confidence added to volatility and weakened the dollar against other currencies. The reverse is happening now; it is expected that the EM currencies will further weaken against the dollar. According to a Merrill Lynch survey, for the first time since 2001, investors prefer US equities over developing economies stock markets.
Turkey’s current-account deficit of a whopping $50 billion by the year end (Moody’s Investor) will see to it that there is a reversal in the Lira–Dollar trends. Analysts are of the view that the Lira, which has appreciated by 10% against the dollar (y-o-y) will fall by approximately 12%. Owing to the large and persistent deficits, South Africa will largely have to depend on foreign capital. The Indian Rupee, which advanced to 12.7% last year, is currently under pressure to weaken further, courtesy the losses in the stock market (since the beginning of the year the market has lost 28.32%), which have raised concerns about capital outflow. The road ahead will be more challenging for the emerging economies as they are bound to witness less of portfolio flows, courtesy the differentiation and the ratings cuts (Fitch Ratings has cut the credit outlook on South Africa and India). Stephen Jen, Chief Currency Economist, Morgan Stanley cites various reasons as to why the South Korean Won (KRW) would also be weaker. According to Jen, “In contrast to most of Asia, Korea does not have energy subsidies. Thus, we expect to see the impact of high oil prices becoming visible in Korea before it does in other countries. The size of the negative ToT shock impinging on Korea is as large as any country in Asia. As a result, the KRW should not be strong.” Globally, as growth decelerates, and as focus shifts from inflation fighting to GDP protection, it is expected that the ratio of US dollar to that of emerging market currencies will gradually drift higher.
The emerging markets today are more concerned about future inflation and consequently a tighter monetary policy; as a result their currencies are selling more aggressively thereby sharply increasing the risk aversion. As far as policy interventions in the emerging markets are concerned, they need to be understood that merely seeking to limit currency fluctuations could end up in fostering more instability. Indisputably, currency movements tend to be oft noisy but in the long term they are a reflection of economic fundamentals.
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