Reversal of FX reserve growth spells danger for ‘fragile five’ EM currencies

EM currencies have dropped sharply as the prospect of the Federal Reserve normalizing its monetary policy has pushed up yields and driven rising volatility in EM bond markets.

However, while the debate about when the Fed will start tapering its asset purchases has driven volatility in EM currencies higher, to some it has merely exacerbated the bear market that has been in place for the past two years.

That would suggest any bear-market rally in EM currencies due to changing expectations over the exact timing of the withdrawal of Fed monetary accommodation should be met with caution.

James Lord, strategist at Morgan Stanley, says the factors that have afflicted EM currencies should be familiar to investors.

The long-term trend has been driven by the deterioration in EM current-account positions, he says – fuelled by subdued growth in developed markets, falling commodity prices, the slowdown in China, and the deterioration in external competitiveness related to elevated real exchange rates and high inflation.

“All this means the various factors that have led to the long-term trend of FX reserve accumulation are starting to go into reverse, with growth rates in FX reserves likely to turn negative soon,” says Lord.

“Against this already challenging backdrop, the prospective normalization of Fed monetary policy simply exacerbates the risks: EM economies are having a hard-enough time attracting foreign currency inflows – whether export revenues or capital flows – and rising US Treasury yields simply supply another reason for capital to flow back to the US.”

To find out which EM currencies look most vulnerable to further depreciation, Morgan Stanley ranked them based on a number of variables that the bank considers important for their medium-term outlook.

They included inflation, real effective exchange rate (REER) levels, exposure to industrial metals prices (a proxy for China), balance-of-payments reliance on fixed-income flows, current-account positions and the bank’s own external coverage ratio – which is an attempt to measure overall external financial vulnerability.

As can be seen, a number of currencies appear vulnerable, including the Chilean and Mexican pesos, the Peruvian sol, the Turkish lira, Indian rupee, Indonesian rupiah, Brazilian real and South African rand.

Morgan Stanley discounts the ranking for the Mexican peso for two reasons. First, its vulnerability centres on a high reliance on fixed-income flows rather than any broad-based vulnerability. Second, the bank believes Mexico’s push for structural reform measures will make the country’s ability to attract capital high compared with other markets.

Meanwhile, while Morgan Stanley believes the Peruvian sol and Chilean peso are vulnerable, risks stem primarily from the high scores associated with commodity prices and China, which possibly overstates the riskiness of these currencies compared with others.

That leaves what Morgan Stanley describes as the “fragile five” EM currencies: the Brazilian real, the Indonesian rupiah, the South African rand, the Indian rupee and the Turkish lira.

According to Lord, these currencies will likely face headwinds over the medium term from various factors ranging from high inflation, high REERs, external vulnerability from initial conditions and vulnerability to further external deterioration based on a heavy reliance on fixed-income flows or China-related risks.

“The risks associated with these particular five currencies are also evident from the fact central banks in these countries have been among the most aggressive in their bid to support their currencies,” says Lord.

Indeed, as the chart below shows, all five countries ran down their FX reserves in May and June, while only South Africa failed to deliver a rate hike to support its currency.

Ultimately, those attempts to prop up their currencies might prove futile.

As Lord notes, EM economies have not had to work hard to attract capital during the past 10 years as various combinations of attractive yields, strong growth and loose developed market monetary policy have meant that funds have flooded in.

Now, he says, with the tide turning the other way, EM economies need to work harder to attract capital, or at least soften the blow.

“Using FX reserves does little except smooth the trend and is ultimately an impotent tool to prevent currency depreciation in the face of systemic balance-of-payments pressure,” says Lord.

“Hiking interest rates is more effective, but in the current context only buys some room for EM. Indeed, with growth already weak, hiking rates risks a steeper downturn and further capital flight.”

Morgan Stanley believes the fragile five are likely to remain under medium-term pressure and recommends accumulating long positions in the dollar on a meaningful dip in the US currency – such as one provoked by a pullback in Fed-tapering expectations.

For those looking for other reasons to be bearish on these EM currencies, there is also politics to consider. Next year sees general elections in South Africa, India, Brazil and Indonesia, while Turkey goes to the polls for a presidential election.

That might just add to the vulnerability of the fragile five.