The bear case for EM FX

Investors are facing “a slowdown in the world’s second-biggest economy, a central bank [the People's Bank of China] that is fighting to prevent more/faster currency weakness, and a clear downtrend in global FX reserves which, all things being equal, will tighten global monetary conditions”, says Kit Juckes, macro strategist at Société Générale.

However, China is not the only threat to EM stability in coming months. Many EM currencies have been hit directly by commodity price falls, and will continue to feel the drag. Trade will be hit if growth remains sluggish in Europe and elsewhere outside the US.

Of 21 EM currencies tracked by Morgan Stanley, only three – all Eastern European: CZK, HUF and PLN – have appreciated against the dollar in the past month. Five – TRY, MYR, BRL, COP and RUB – have depreciated by more than 10%.

Eric Viloria, currency strategist at Wells Fargo, notes that Latin American currencies have been among the weakest-performing EM currencies this year, partly due to their sensitivity to commodity prices.

This, combined with poor internal conditions – notably sluggish growth and relatively large current-account deficits – is likely to mean further declines for LatAm FX, he says.

Viloria is especially bearish on the Brazilian real – Brazil having the weakest growth in LatAm – and the Colombian peso, the weakest-performing currency in the region this year.

However, their problems will be even more acute if the Fed pushes ahead with its plans to raise rates, which many expect it will this year. That will increase the cost of their dollar-denominated debts, and make investments in the US a more attractive alternative.

In Colombia, for example, the current-account deficit now stands at 5.9% of GDP. In terms of external balances, therefore, the peso “is likely to be among the more vulnerable of emerging currencies in an environment of eventual Fed tightening”, says Viloria.

However, many other EMs will feel the squeeze when US rates rise. Turkey and South Africa, as well as Brazil, have high foreign capital funding requirements, which will become increasingly expensive.

This illustrates the dilemma facing the Fed: if it raises rates as planned, it risks exacerbating an already volatile situation for EMs and beyond. However, while postponement of a rate hike might give some short-term relief, markets could interpret it as a sign things are going wrong with the global economy, states Deutsche Bank in a fixed income research note.

This might create panic in its own right, and in times of panic EMs have traditionally been among the first casualties, as investors abandon their careful credit analysis in favour of a “sell now, ask questions later” strategy.

If investors are in the mood to be selective, Deutsche argues: “Emerging markets facing domestic political problems and/or with high US dollar-denominated debt burdens may be most at risk.” That would put Russia, another country heavily reliant on commodity exports that suffers from considerable political risk as its economy continues to be strangled by sanctions, squarely in the firing line. Thailand’s political situation will also deter investors in a risk-off environment, as will Brazil’s.

The taper tantrum of 2013 will be fresh in the mind for all EM investors. It showed how dramatic the market’s response to Fed diktats can be, and, arguably, how addicted they have become to low US rates.

Whether quantitative easing has had the desired impact on growth is debatable, but there is little doubt it has pumped up risk assets, such as EM credit, which rely on accommodative policy to support valuations, says Deutsche.

Commentators are therefore divided about what the Fed will do. Deutsche believes the global growth outlook is so weak the Fed will ultimately avoid raising rates, stating: “Even if the US looks better than its trading partners, whether it likes it or not, the global economy matters a lot.”

Deutsche believes carnage can be avoided if the Fed avoids raising rates, but if it decides to push ahead with plans to raise rates, or commits strongly to doing so later in the year, “we would fear that the market would test the year’s low and possibly go through”, it states.

William Lee, head of North America economics at Citi Research, is also concerned about the impact US rate rises will have on risk assets such as EM credit – regardless of their timing.

“Just because the Fed promises that rate hikes will be gradual, that does not mean the response will be moderate in all asset classes,” he says.

Lee explains: “The less liquid asset classes in particular, such as EM credit, require market makers to function properly and with those institutions cutting their risk appetites and VaR limits accordingly, this reduces their market-making capabilities by around a third, relative to where it was pre-crisis. “So if investors holding these higher yielding assets decide to unwind their positions to reallocate to domestic credit, and if everyone decides to move at once rather than waiting for the right moment, there could be disorderly markets.”

Lee believes some are taking for granted the ability of institutional investors such as pension funds and insurance companies – arguably the natural buyers for this paper – to step in as buyers of EM credit and other high-yield assets, which might be available at a discount.

“They may not have the necessary liquidity to be the buyer of last resort for this much paper,” he warns. “This could mean EM credit spreads go ballistic.

“I am not sure the Fed is as concerned about this as it should be. Every crisis is characterized by a broad emphasis on one strategy and right now we see that everyone is in the same boat: long dollar.”

EM central banks are on alert. In China’s backyard, the South Korean finance minister promised action in the market to maintain order, without going into specifics. Further afield, the South African Reserve Bank also indicated it stood ready to intervene in FX markets if necessary, to protect the country from “developments that threaten the orderly functioning of markets” and financial stability.

It is not clear such verbal interventions have made much impact at this stage, though it is also possible certain currencies would have been harder hit, absent words of encouragement from central bankers.

However, with China’s malaise set to continue, and the Fed facing a tough decision on rates, EM central banks might be forced to back up their words with drastic action to protect their economies in coming months.