That raises the prospect of whether the world is on the verge of another bout of currency wars or if EM central bankers are just living on borrowed time.
The EM sell-off in June that followed the Fed’s first utterances on reining back its quantitative-easing programme caused a sharp drawdown in FX reserves as regional central banks sought to defend their currencies.
The hardest hit currencies were those of deficit-laden economies, hamstrung by low growth, such as the Indian rupee, Indonesian rupiah, Brazilian real, Turkish lira and South African rand. As the Fed threatened to turn off the global liquidity taps, the global currency wars were forgotten as EM central banks were forced into the market to prop up their currencies as investors moved to withdraw capital.
However, the tide turned in the EM currency rout after the release of the minutes of the Fed’s June meeting on July 10, when the central bank backtracked on the idea it would begin to taper its asset purchases.
Price action since then suggests investors have been abandoning the dollar, a trend that was given further impetus after the Fed confirmed it would not be reining back its asset-purchase programme at its September meeting.
Subsequent weak US economic data, and the fallout from a potentially damaging government shutdown and debt ceiling stand-off, have seen expectations mount that any tapering from the Fed will now be postponed until well into next year.
That change in sentiment has seen capital redeployed into EMs. Evidence for that comes from a number of sources.
First, the latest US government TIC data show that official holdings of US treasuries rose by $12.2 billion in August.
As Ryan Klein, market economist at Action Economics, notes, higher levels of official inflows into treasuries tend to be associated with FX intervention from EM central banks as they grow their reserves defending against dollar weakness.
Second, although the IMF only produces its Cofer data on the size of global FX reserves quarterly, more high-frequency data show that stockpiles are rising.
Indeed, by looking at countries such as Mexico and Turkey, which report the size of their FX reserves weekly, or countries that report monthly – such as China, Brazil, Taiwan, South Korea, Hong Kong, Singapore, Indonesia, Thailand and the Philippines – it can be seen that not only has the decline in EM stockpiles seen at the start of the summer been reversed, they are hitting fresh highs.
That is because figures reveal that the countries above, excluding China, have fully reversed the $40 billion decline seen in their reserves between April and July. Official data, meanwhile, revealed China added $163 billion to its stockpiles in the third quarter.
Even taking into account the valuation effect of a falling dollar, those 11 central banks – which account for about half of the world’s $11.4 trillion of reserves – have added about $150 billion to their stockpiles since the dollar turnaround in July.
The question is whether this heralds the start of a long-term rally in EM currencies as investors chase carry.
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| Maurice Pomery, chief executive at FX consultancy Strategic Alpha |
Maurice Pomery, chief executive at FX consultancy Strategic Alpha, urges investors to be selective, arguing that countries running high current-account deficits might still not be attracting the high-quality long-term real money investors that others might. Instead, he believes rallies in the likes of the Brazilian real and the Turkish lira are being fuelled by bargain-hunting investors, such as hedge funds, that are more willing to take on risk.
That said, Pomery believes the postponement of Fed tapering will lend EMs support in the short term.
“I see a run into Christmas, and maybe a little longer, into the EM space,” he says. “Whether that is going to be hot money or real money makes a big difference.
“If it is hot money, which I think it will be – such as hedge funds and bargain hunters – then the move will be significant, but I don’t think the money will stay there long if there are problems again.”
Indeed, price action in the currency markets suggests it is east Asia countries, sporting current-account surpluses, that have benefited the most from real-money inflows and exhibited the least FX volatility among EM currencies over recent months.
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| Axel Merk, president and chief investment officer at Merk Investments |
The likes of the Turkish lira and South African rand stand well below levels seen in April. Meanwhile, the renminbi, Korean won and Taiwan dollar have all broken back through the highs seen that month. “It is no surprise to us that Asian countries with strong external balances, such as China, Taiwan and Korea, have weathered the storm so far much better than India, Indonesia, South Africa or Brazil, and investors may want to deploy their capital selectively within the emerging markets,” says Axel Merk, president and chief investment officer at Merk Investments.
Merk believes that one lesson thrown up by the rout in EM assets in May and June is that authorities need to take the chance to reform their financial systems, offering investors a greater array of financial instruments in which to put their funds and a predictable regulatory environment.
He says instead of threatening the market with capital controls at the first sign of trouble, EM policymakers should be looking to open up their markets.
“Long-term investors may find better risk-adjusted returns in those countries embracing reform than those fighting investors,” says Merk.
The Fed-induced return of stability appears to have given EM authorities some breathing space, both from the immediate threat of an exodus of capital and from the need to enact reform.
If and when the tide goes out as the Fed begins to taper its asset purchases, they might well be tested again.