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Emerging currencies: central banks are faced with squaring the circle


The Federal Reserve's bias, which is more accommodating than expected, offered emerging markets a little respite by limiting the volatility of US Treasury bonds.

The virtually unchecked decline of the emerging currencies against the dollar is stirring up fears of either worsening emerging fundamentals or a rise in local interest rates in response to an exodus of foreign investors. 

The second prospect is far from the likeliest in the short term. An investigation of the factors underlying currency volatility shows that the main macro risks at present are well priced in. 

However, in the medium term, emerging economies are going to be on the horns of an economic policy dilemma: trying everything to keep their currency from depreciating, to avoid the automatic rise of the cost of funding their debt in non-domestic currency.





Emerging markets have earned a little respite

Sooner or later, the Fed will tighten its interest-rate policy, which could have consequences on emerging currencies: everyone still remembers the sharp depreciation of emerging currencies after Ben Bernanke suggested, in May 2013, that the Fed could taper its asset buying (the "taper tantrum"). It has been repeatedly stated in this publication that the monetary tightening will most likely be slow, and that its scope will be far more limited than in previous cycles ("China and Europe: the bull in the china shop of US monetary normalisation", Cross Asset Investment Strategy, March 2015).

At the FOMC on 18 March, even though the Fed did leave out the fact that it would be "patient in beginning to normalise the stance of monetary policy," the Fed has clearly postponed its tightening cycle by massively lowering its Fed fund projections (also known as the "dot plot"), which gives emerging countries a little room to breathe. Ultimately, for emerging currencies, the Fed's moreflexible-than-expected position is the biggest news of the past few months.

On the other side of the Pacific, China, whose foreign exchange policy decisions have significant repercussions on the other emerging currencies, especially the Asian ones, has, by all appearances, opted for a relatively stable yuan against the dollar in the short term (in this edition, see the text "China walks a tightrope: attempting sterilised stabilisation rather than traditional devaluation")

The stabilisation of exchange rates among the world's three major currencies – dollar, euro and yuan – offers some respite to emerging currencies after a wave of brutal adjustment. It looks like the pressures on emerging currencies coming from those two heavyweights should continue to materialise during the year.

A "dollar tantrum" in the wake of the "taper tantrum"

The dollar's appreciation, which has accelerated since last summer, has resulted in significant depreciation of the emerging currencies. This new stress episode is a reminder of the "taper tantrum", only a longer and harsher version. With the same causes having the same effects, we easily associate the new decline in emerging currencies with the divergence of monetary trends between the Federal Reserve and the ECB (see Chart 2). In addition, we see that the implied surplus volatility of the emerging currencies – the gap between the emerging VXY implied volatility index and that of the G7 – has become quite unstable in the recent period of major divergence in monetary policy anticipations between the Fed and the ECB.

Still, during the "dollar tantrum", very few currencies behaved the way they did during the "taper tantrum". Comparing the paces of annualised depreciation in both episodes reveals a reversal of hierarchies in terms of depreciation. In other words, the currencies that suffered most in 2013 are among those that, in relative terms, lost the least during this phase of dollar appreciation.

History stutters, but doesn’t repeat itself

This lends credence to the assumption that a good portion of the macroeconomic imbalances emerging economies has been absorbed by investors, and consequently in the exchange rates, since the "taper tantrum". To confirm this assumption, you need only to compare the valuation of the emerging currencies just before the "taper tantrum" – that is to say, June 2014 – with their depreciation rate since then.

Comparing the pace of depreciation of emerging currencies since June 2014 with the change in the real effective exchange rate1 between April 2013 and June 2014 highlights that the currencies that proved the most resilient are those whose real effective exchange rate depreciated most in the first tantrum.

However, there are two groups of currencies that deviate from this observation: the currencies of Central Europe (Polish zloty, Hungarian forint, Czech koruna, and Romanian leu) and four currencies of commodity exporters (Chilean, Mexican and Colombian peso, and Malaysian ringgit). In the fi rst case, the consequences of deflationary pressures in the eurozone are clear. In the second, the intensity of the shock on commodities due to the dollar's appreciation will have managed to undermine even the hardiest producing economies.

The cyclical component of currencies has largely absorbed current trends

In the short term, we anticipate that emerging currencies will stabilise. This conviction is based on an analysis of their variance and an interpretation of common factors that explain emerging currency volatility at a one-year horizon. Three fundamental factors emerge: China's economic momentum, the behaviour of commodity prices, and, lastly, the vigour of the European recovery, measured as the positive differences between the eurozone economic performance and the consensus expectations2.

It is easy to understand the importance of these factors, because China is a systemic economy for the global economy, most of the emerging markets produce commodities, and Europe is one of the top importers for the vast majority of them. Whatever the case, on average, these three factors combined account for 80% of emerging currency volatility against the dollar.

And with each fundamental factor comes a basket of currencies. As such, this correlation can be used to evaluate the anticipation over the factor considered to be implicit in currency behaviour. At present, emerging currencies are showing excessive pessimism on the short-term economic outlook in China, and probably excessive optimism on the vigour of the European recovery (see Charts 5 and 6). The behaviour which, in the background, underlies these conclusions, is essentially in the poor performances of high-yield currencies such as the Russian rouble and Brazilian real, just as much as the poor performances of Latin American currencies (Chilean, Mexican, and Colombian pesos, Peruvian sol) or the Malaysian ringgit. All of these currencies are expected to rebound against the dollar in the second quarter.

An outlook that is subdued in the medium term

That being the case, the depreciation of emerging currencies against the dollar during this extended period of unrestrained appetite for the dollar potentially reflects two distinct outlooks: either an anticipation of the emerging fundamental risk deteriorating, or an anticipation of an increase in the rate spread between the emerging currencies and the United States3. Neither option is friendly to emerging economies, especially in a context of rate normalisation – even if gradual and late – by the Fed.

The risk of a rapid rise in US rates seems limited at this stage. In the first place, the Federal Reserve being more gradual than anticipated shows that tensions are weakening over the US curve's forward spreads – the difference between short-term rates and long-term rates. A highly appreciated consequence of this reduction in tensions on the forward spread will be a reduction in the volatility of US bonds.

From the viewpoint of emerging rates, a decline in volatility of the asset considered to be risk-free – US bonds – is a significant supporting factor. In concrete terms, the volatility of emerging currencies is expected to fall, which could limit a risk of soaring rates related to a withdrawal of capital from foreign investors. As for sovereign debt in dollars, the current appeal of the spread carry should make it possible to absorb the impact of the rise in US long-term rates. Assuming a spread on the EMBI Global Diversified Index going down to 350 bp by Q1 2016, the performance of the index could approach 4%.

There is an opposition between high-leverage economies and those with large domestic imbalances

With our approach of segmenting the emerging countries in ascending hierarchical classification (see "A global approach to emerging markets typology", Cross Asset Investment Strategy, September 2014), we can divide the world's 31 major economies4 into four blocs. A China bloc formed by China and its major partners in Asia5, a European bloc including the economies of Central Europe and the advanced economies with the best sovereign ratings (Germany, Netherlands and Sweden), an advanced bloc including the US, the UK and the eurozone's other core countries (France, Italy and Belgium), and, finally, a bloc of emerging economies in transition, including the emerging economies of Latin America, Indonesia, India, Russia, South Africa and Turkey. 

Generally speaking, there is an opposition emerging between high-leverage economies – specifically those for which the external debt stock6 (in relation to GDP) in dollars is high: primarily Asian economies, particularly China and its partners (Malaysia, Thailand, Korea), and the economies with major domestic imbalances, whose most worrisome symptom for the fixed-income markets is inflation. In this category we have the Russian, Brazilian, Turkish, Indonesian and Colombian economies. These latter will quickly be confronted with the need to toughen their monetary policy bias. Only Brazil is quite far along in this process. For the two blocs – China and partners, vulnerable economies – the major medium-term risk is one of capital flights that could create financial stress due to a currency mismatch.

The emerging economies’ search for the "grail": Reassuring investors without disrupting growth

No doubt these countries' central banks will have to adapt, or even change, their monetary policy direction, as was the case for the PBoC, which took strong action on the forex market in mid-March to limit downward pressure on the yuan. The response from the various central banks to the pressures exerted by markets on exchange rates will mainly depend on their economy's sensitivity to currency variations and to external financing requirements. Put another way, the more vulnerable to and dependent on foreign debt an economy is, the more the central bank will try to limit the currency depreciation, which would increase the debt burden in foreign currencies, cause a flight of foreign capital and, ultimately, increase the vulnerability of the country in question, via a negative spiral among these variables (see box).

Different metrics can be used to gauge this sensitivity, the most important being the share of debt held by non-residents (i.e. external debt, whether denominated in local currency or foreign currency), the weight of debt servicing, the investment requirements that can be estimated using the current account balance and the share of domestic savings, currency reserves, the interest rate spread with advanced countries (United States and eurozone), and the real growth and interest rates.

To anticipate the possible reactions of the different emerging economies' central banks, then, it seems essential in the short term to closely analyse and track these metrics. Likewise, beyond the anticipation of the central banks' reactions, it is the impact of their decisions that must be assessed. Indeed, if the central banks find it necessary to intervene, they have two orthodox instruments: their foreign exchange reserves and/or their key interest rates. If there are prolonged pressures on the currency, foreign exchange reserves may not be enough to stabilise the exchange rate, and the only alternative in these circumstances is raising key interest rates or turning to a more heterodox solution: capital controls.

In a sluggish overall environment, with the prospect of a slowdown in growth in most emerging economies in 2015, a hike in the key interest rates may be less than optimal from the standpoint of sustaining growth. In this respect, Russia, Brazil and, to a lesser degree, China seem especially vulnerable, due to specific political factors. Tightening monetary policy has a recessive effect on the economy, because it is a drag on investment (due to its rising cost) and increases the debt burden (thus limiting the options for budget stimulus).

In conclusion, the monetary authorities of the countries that must at least stabilise their currency will be faced with a challenge: to set the interest rate at the "right" level, to both limit the increase in debt servicing and capital flights (i.e. find a balance between high interest rates that would stabilise the exchange rate but weigh down debt) and too-low interest rates to prevent capital flights from the country, knowing that the ultimate solution would be to re-establish capital controls.

The emerging countries' economic policy dilemma: stabilising the currency to stabilise foreign debt

The traditional choice of a devaluation to counter an economic slowdown is invalid when a country's external debt becomes unsustainable, whether it is contracted in local or foreign currency, by the private or public sector. Indeed, two opposing effects come into play: first, devaluation promotes competitiveness and therefore growth, via the recovery of net exports; second, external debt servicing also increases, and, because of this, has a negative impact on growth.

Beyond the scope of the devaluation itself, the net effect depends on the relative scope of these two opposed movements, which are in turn determined:

  • for net exports, by the size of the exporting sector and the momentum of global demand for the country in question;
  • for the debt burden, by the size of the external debt stock, as well as the scope of the interest rate spread with the reference currency.

Indeed, in a normal domestic and international macroeconomic environment (no debt surplus, particularly external, and sufficiently buoyant external demand), the positive effect on net exports wins out over the negative effect on debt servicing. This is the reason for traditional devaluations, because stimulating growth means being able to service debt: they restore the sustainability of the debt-to-GDP ratio by stimulating the denominator without touching the numerator (debt restructuring).

However, in an abnormal domestic and international macroeconomic environment, as we have now (excess external debt held by non-residents and not enough external demand), a devaluation has the opposite effect: it pushes the cost of debt servicing higher than the marginal gain in growth from the recovery in exports. In simple terms, in a case of external overindebtedness, a devaluation erodes the sustainability of external debt and, 
paradoxically, heightens rather than reduces the risk of default.

Foreign investors may want to test or even prepare for this perverse mechanism to materialise in the countries they find to be over indebted and, in so doing, begin to withdraw their funds, leading to a fatal depreciation of the local currency. Obviously, this is a risk of self-fulfilling prophecies that leave host countries only one option for coming out on top: sterilised stabilisation of the local currency, which means preventing a devaluation with no recessionary widening of the rate spread.

To be effective, this strategy requires that foreign investors be dissuaded, one way or another, from withdrawing their capital from the country:

  • having enough macroeconomic and political credibility to convince foreign investors to stay in (or even enter) the country;
  • re-establishing capital controls, which amounts to forcing foreign investors to accept playing the game of a sterilised internal stabilisation.

In the first case, macroeconomic and political credibility is enough by itself to win over foreign investors, so the objective must be to preserve it. In the second case, the strategy's success ultimately comes from the credibility acquired during the application of capital controls: this objective means adding a short- and long-term growth strategy to these capital controls that must include clearing the debt surplus, a budget stimulus and structural reforms.

The first case is well-illustrated by India, which seems to be in a position to become the new flagship destination for foreign investors: there can be little doubt that credit for this goes to the credibility of the pairing formed by Central Bank Governor Raguram Rajan and Prime Minister Narendra Modi. Without minimising the role of the restrictions already in place, the markets seem ready to credit this pairing with a macroeconomic policy that is suited to the country's condition (i.e. monetary, budgetary and structural reforms).

As analysed in the article on China, "China walks a tightrope: attempting sterilised stabilisation rather than traditional devaluation" , in this same issue, in the event of higher external debt, the government must be more proactive. In a certain sense, this is the message from China in recent weeks: while the PBoC has refocused the yuan on the corridor's central value (instead of expanding it as in 2014), the Chinese Prime Minister announced a targeted budget stimulus, given that China is in the process of finalising its transition to a market economy.


1 A consistent valuation measure would involve estimating the spread of the real effective exchange rate at equilibrium. Given that the period under review is no longer than nine months, the change in this metric will largely be explained by the variation in the real effective exchange rate itself.

2 Also known as economic surprises.

3 That is, in substance, what the principle of parity for unhedged interest rates states. If two economies have equivalent fundamental profiles, and their debts are fully interchangeable, then the variation in the exchange rate of their respective currencies must be equal to their rate spread. Consequently, the non-parity of rates, i.e. the nonequivalence of the fundamental profiles, means that the variation in the exchange rate is equal to the rate spread adjusted for a risk premium. 

4 Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, France, Germany, Hungary, India, Indonesia, Italy, Japan, Malaysia, Mexico, Netherlands, Peru, Philippines, Poland, Romania, Russia, South Africa, South Korea, Sweden, Switzerland, Taiwan, Thailand, Turkey, United Kingdom, United States.

5 China, Japan, Malaysia, South Korea, Taiwan, Thailand.

6 External debt is debt held by non-residents, regardless of the currency – local or dollars.









For the emerging currencies, the Fed's more-flexible-than expected position is the biggest news of the past few months







Emerging currencies are excessively pessimistic on the short-term economic outlook in China






The depreciation of emerging currencies against the dollar reflects either an anticipation of the deterioration of the emerging fundamental risk, or an anticipation of the rise of emerging rates






If the dollar stays high, emerging central banks, specifically from countries seen as "vulnerable" by the markets, will have to properly target their interestrate level to ensure they come out on top

















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BEN ABDALLAH Marc-Ali , Senior Analyst, Investment Solutions
DOISY Nicolas , Strategy and Economic Research at Amundi
DRUT Bastien , Fixed Income and FX Strategy
HERVE Karine , Emerging Markets Senior Economist
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Emerging currencies: central banks are faced with squaring the circle
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