With January drawing to a close, one can only conclude that it was dominated by risk-off trading activity. In the last trading week of the month, investors continued to sell equities and moved money into assets they perceived to be safer, such as US or German government bonds, and commodities, such as gold. Hardest hit were emerging market stocks, which the FT reported saw a money drain of more than $12bn in January 2014. However, today all stock markets suffered, with both the S&P 500 and the EuroStoxx 50 down almost one percent.
Hot money flows not only sent EM stocks dwindling down but especially caused heavy losses in the respective countries' currencies. Since many emerging market economies already suffer from current account deficits or political complications and rely heavily on imports, the depreciation of their local currencies seen in 2014 so far represents a serious risk for their further economic growth and recovery.
In Turkey, the main risk remains the country's prime minister, Recep Tayyip Erdogan, who at first opposed a rate hike deemed necessary by most economists and who desperately fights for being able to keep his political power, apparently believing that the country is being undermined by foreign conspirators. As became evident over the past few months, Turkey suffers from a high level of corruption. Just this week the government removed another 800 police officials and many prosecutors from their positions. The Turkish lira is all the more vulnerable because the country's foreign reserves are draining off. If the recent increase of the deposit rate does not keep hedge funds from betting against the TRY, the central bank will only have very limited resources available to support the currency. Earlier this week, Mr Erdogan told journalists that he had additional fire power ready to support the TRY, but he did not give any details or supporting facts, which will hardly convince professional investors that the government will be prepared to fend off TRY shorts.
Inflation also poses a challenge for South Africa, whose currency has already fallen some 6% against the US dollar. The country's unemployment rate is a whopping 25% and there continue to be crippling mining strikes. South Africa is slightly better off in terms of foreign reserves than Turkey, though. It also recently raised interest rates to stop the decline of the ZAR. From a technical point of view, we believe that USDZAR short may be a nice short-term trade idea. As of now, the ZAR trades below 11.14 and just today managed to stay well away from its low around 11.38. With ZAR short positions already at very high levels, technical oscillators such as the RSI indicating that the currency is temporarily oversold and EM central banks finally waking up, we see a chance that the ZAR will recover against the USD over the next few weeks but recommend setting SL limits not too far away.
Thursday saw the Turkish lira (TRY) decline further despite the Turkish central bank's surprise move from Tuesday night to more than double the weekly repo rate to 10 percent (although effectively this was more like a 7 to 10% hike considering that the CB had previously not lent money at the official rate of 4.5%). The decision was all the more bold given Recep Tayyip Erdogan's clear opposition to higher interest rates.
At first, the TRY quickly rebounded from its all-time low against the USD of more than TL2.39 to roughly TL2.16. However, that has only been a temporary breather with hedge funds well aware of Turkey's economic and political challenges as well as the central bank running out of foreign currency reserves. On Thursday, the situation turned worse again following both strong economic data releases from the US and disappointing news from Turkey where it has been reported that the government again removed more than 800 police officials and 90 prosecutors from their positions. The political struggle is far from over, causing further USDTRY volatility.
Other EM currencies faced similar challenges. For instance, the decision in South Africa to carefully raise rates on Wednesday, although a surprise, was not as bold as the rate increase in Turkey and was very short-lived, too. The Rand is among the biggest EM currency losers and currently trades at ZAR 11.21 per USD. Emerging market woes were additionally fuelled by the Federal Reserve's clear stance to continue to reduce its monthly asset purchases. In Ben Bernanke's last speech as Fed chairman, he did not mention the emerging markets with one word, hinting at the US just not caring about the problems of the weaker countries.
A few days ago, the FT published an interesting article as part of the "Chart of the Day" feature on its Beyond BRICs blog contrasting the development of EM currency spot rates with central banks' foreign reserves. The chart has been of interest because the story it tells may be different from what you would expect in light of the sharp devaluation of EM currencies: In most EM countries, foreign reserves did not decline markedly in August 2013 and in some countries, such as Indonesia and Turkey, foreign reserves even increased.
When a country's currency gets under pressure, you might expect central banks to intervene in the FX markets in order to support the local currency. However, most central banks must have realized that the international capital markets have become too big to bet against by actually using up foreign reserves. Verbal announcements and interest rate changes have become the main tools of central bankers, as it seems. (Indonesia did reduce foreign reserves throughout 2013 but failed to halt the rupiah's fall.) On the other hand, Asian central bankers have perhaps not forgotten about what happened with the GBP in 1992, when the Bank of England practically ran out of reserves and ultimately had to abandon its policy of supporting the British pound.
While some EM economies recently introduced capital controls to strengthen their local currencies and acted to reduce inflation, which in some cases has reached problematic rates, they have not attempted to buy their currency on a large scale. This behaviour would conform with the theoretical concept of the "foreign exchange trilemma" or the "impossible trinity", which says that you cannot implement a fixed exchange rate, free capital mobility and an independent monetary policy at the same time. As per the theory, it is only possible to achieve two out of these three (generally desirable) objectives. Apparently, EM economies have decided to let their exchange rates float (almost) freely even during these turbulent times, because they already have implemented the other two policies and don't want to or can't let either of them go. (This trilemma has been criticised in the academic literature over the years, and I am going to present a selection of papers on this subject on this blog shortly.)
It should be worth keeping an eye on the foreign reserves of emerging markets, just in case the decline of the region's currencies continues in the following months and central banks might decide to begin selling their reserves in exchange for their respective local currencies. For the time being, however, EMs seem rather willing to wait through the current phase of increased FX rate volatility.
Emerging market currencies continue to be under pressure after a brief recovery following the Federal Reserve's announcement from last week not to reduce its stimulus programme for the time being. The Indonesian rupiah (IDR) was hit particularly hard. The USD/IDR exchange rate marked a new two-year high of 11,585 earlier today. As of this writing, the IDR trades at 11,492 to the dollar.
EM currencies have not been able to sustainably regain their losses against the dollar, despite the Fed's decision to delay the tapering of its monetary easing efforts. Instead, EM currencies remain under scrutiny by investors, who are now closely watching the respective countries' economic data releases and especially their current account deficits. They have woken up to the fact that money only flowed into emerging markets because of lower yields elsewhere. Now that the hot money flow is not as liquid anymore, fundamentals get renewed attention. Asian economies have relied heavily on leverage and they are now forced to come up with reforms that will satisfy investors or otherwise their currencies will continue to depreciate, which would put further stress on the region's central banks and the CB's foreign reserves. Considering that Asian governments have focused more on quick growth than long-term policies over the past few years, it is unlikely that liquidity will stay in the region. It is more likely that nervous investors will continue to sell EM currency holdings whenever possible. Accordingly, the outlook for Asian currencies remains tough.
Yesterday, the Indian rupee (INR) fell to a new record low against the US dollar following one of the currency's most extreme down moves since the mid 1990s. The INR currently trades around Rs68.25 per USD after having been close to Rs69 in earlier trading.
The decline of the INR continues amidst multiple sources of risk, with the most recent being the expected Western military intervention in Syria. Emerging market economies are already under pressure from external and internal sources:
First, there are market expectations of the US Fed getting ready to taper its monetary stimulus programme as soon as September, which have already triggered first hot money flows out of EM currencies. Investors in EM currencies are advised to closely watch any US economic data releases, because these could hint at the timing and size of any such steps by the Fed.
Secondly, EM economies feature large current account deficits -- a home-made source of risk that may not be underestimated. A significant amount of Indian debt is denominated in US dollars and owned by foreign investors. The depreciation of the INR increases this debt burden in local currency terms, posing a big risk for the Indian economy.
It is still too early to tell whether the depreciation of emerging market currencies has been a temporary trend or the beginning of a full-blown EM crisis. Investors with exposure to EM currencies may therefore be well-advised to protect themselves against further FX losses via hedging strategies, as the already bad situation may well turn into something much bigger once the Fed actually starts tapering and the first images of US/UK/French bombs exploding in Syria appear on TV screens worldwide.