Emerging market currencies: A well-thought-out crisis
Behold, a selloff in emerging market currencies is at hand. While the story is familiar, markets have turned up the drama; this is no plot twist – the trend hasn't changed, it has only become sharper.
The Turkish Lira and the Argentine Peso have been declining since talk about the Federal Reserve tapering its bond purchases began last May. Now that talk has turned into reality, it's no surprise that these currencies have continued to weaken. The recent moves have been a change only in terms of speed, not direction.
The trigger may have been the announcement of a disappointing Purchasing Managers' Index from China, but that only explains the jump – not the trend.
(Read more: Emerging-market currency 'contagion' spreads)
Ever since outgoing Fed Chairman Bernanke started talking about tapering last May, the market has been pricing in more difficult times for countries such as Turkey. This can be seen in the graph above, which gives the average performance of the U.S. dollar against 21 emerging market (EM) currencies divided into two groups: nine with current account surpluses and 12 with current account deficits. Note, the ARS is not included because it's such an outlier after last week's devaluation.
The notable point is how the two lines largely moved together until May, when the tapering talk began. From that point on the FX market started to price in the gradual withdrawal of Fed liquidity, a process that has just gotten under way. Although the FX market did begin to discount the Fed move well ahead of time, it's no surprise that it would continue to adjust as liquidity does in fact start to recede.
Looking at this relationship in more detail may give us some insight into the process and which shoe may drop next. In the graph above, I took 19 of these EM currencies (omitting the SGD and TWD given their double-digit current-account surpluses) and graphed them against the market's forecast for their current account balance this year.
The relatively high correlation in this graph suggests that the impact of tapering has been fairly orderly and well considered, with little knee-jerk contagion. The currencies that have depreciated the most have generally been those with the worst fundamentals, and the degree to which they have depreciated reflects their fundamentals fairly well. There hasn't been an indiscriminate sell-off in EM currencies at all.
The TRY and ZAR have been the worst performing of these currencies, and with good reason. Both countries are suffering from political turmoil while their extremely wide current account deficits need to be funded through capital inflows – a tall order unless investors believe either that the government is taking steps to rectify the situation, as is the case in India, or that assets are so cheap it doesn't really matter. I don't see much resolve by the government to make the sort of fundamental reforms that would attract the international investment community, so I can only imagine that the market will continue to sell these currencies further.
With the TRY now perhaps the most undervalued currency in the world (126 percent undervalued vs USD on a purchasing-power parity basis, according to the OECD) it may eventually reach a point where the market says "enough is enough," but it's hard to say where that would be.
At the same time, notice how the IDR has depreciated almost as much as the ZAR despite Indonesia's much narrower current account deficit and the orderly political transition under way there. The market is forecasting that Indonesia's deficit will narrow significantly this year, growth will remain strong and inflation should come down a bit – which should be a recipe for an appreciating currency. While the country did put a partial ban on mineral ore exports, it is opening up several areas to direct investment, and the relatively high yields on offer should continue to prove attractive to investors. I think IDR could be oversold at this point.
There are a few even bigger outliers: the KRW, the PHP and perhaps the RUB on the one hand, and the PLN and perhaps the PEN on the other. I would like to focus on the KRW and the PLN, the two most extreme cases, because I think there are particularly good opportunities there.
There are a variety of reasons why the KRW may have cheapened recently, but I'm not sure they are convincing: the Korean government has been pressuring the Bank of Korea for a policy rate cut; funds have been flowing out of the equity market; and in the background is the fact that China is far and away its largest trading partner. However, the Bank of Korea resisted the call to loosen, flows into the debt market remain strong, and the current account balance continues to improve despite the slowdown in China. It strikes me that in an environment in which the market is willing to pay a premium for sustainability, the KRW should be appreciating. It seems like a good buy.
The PLN on the other hand managed to appreciate vs USD despite a large current account deficit. Is this sustainable? The currency is already relatively cheap (69 percent undervalued relative to the dollar, according to the OECD). The economy is recovering, the economic data are improving, inflation is low but rising and some analysts expect rate hikes later this year. While the country still has a current account deficit, it has narrowed considerably over recent years (from 8.1 percent in 2008 to an estimated 2.6 percent this year). There seem to be good reasons why the PLN has outperformed and why it will continue to do so. I wouldn't try to outguess the market on this one.