The Emerging-Market Currency Rout

Andrés Velasco

exchanging currency


SANTIAGO – With the currencies of Malaysia, Indonesia, South Africa, Turkey, Brazil, Colombia, Chile, and Mexico hitting record lows recently, currency traders around the world are asking: How much further can emerging-market currencies weaken?
 
The standard approach to answering this question takes a relatively normal base year and measures how much a country’s currency has depreciated since then. That number is then adjusted for the inflation differential between the country and its trading partners. If the resulting real exchange rate is not too far from that of the base year, the market is said to be in equilibrium, and little or no further depreciation should be expected.
 
Now consider an alternative method. Take the same country’s current-account deficit and ask how large a real depreciation is needed (making some assumptions about trade elasticities along the way) to close that external gap. If the recent real depreciation achieves that threshold, no further change in the exchange rate should be expected.
 
These are the right answers, but to the wrong question. Over the medium to long term, exchange rates are indeed driven by what happens in the real economy. Or, more precisely, they reflect the requirement that the real exchange rate be such that the economy attains both external balance (a small and manageable current-account deficit) and internal balance (no inflationary pressures at home).
 
But that need not happen until many months – perhaps years – after a shock. In the short run, exchange rates are driven by purely financial considerations. That is why they are prone to overshooting. Even small changes in fundamentals can have large effects on exchange rates, with up-front movements that far exceed what long-run adjustment requires. And the potential for volatility is particularly great if domestic corporations have large foreign-currency debts, which is true in all of the emerging economies under stress today.
 
Consider the case of a hypothetical Latin American retail company that borrowed abroad in dollars to build a shopping mall at home. Such borrowing calls for collateral – in this case, the land on which construction will take place. The larger the value of the collateral, typically measured in domestic currency (or in an inflation-indexed unit, such as Chile’s Unidad de Fomento), the larger the size of the dollar loan.
 
Next, suppose that the price of the natural resource that is the country’s largest export suddenly dips sharply (as has happened recently). The exchange rate (both nominal and real) will depreciate accordingly, thereby setting in motion the standard, textbook adjustment process.
 
But in this case, a second, non-standard factor comes into play. After the depreciation, the collateral, valued in dollars, is worth less. Loan covenants have likely been broken, and lenders begin demanding that the borrower either put up new collateral or deleverage and repay part of the loan.
 
To repay, the firm must purchase dollars. If there are large dollar debts outstanding, and many firms find themselves in the same position, the additional demand for dollars will cause the exchange rate to depreciate even further. And that, of course, causes the dollar value of the collateral to fall yet again.
 
You can see where this story is going. The process plays out until the domestic currency has lost a good deal of its value. After a few days or weeks, the exchange rate is likely to be weaker than is warranted by the need to adjust the current account. The overshooting is caused by the coexistence of sizeable foreign-currency debts and financial (collateral) constraints.
 
Notice that if in the long run the debt is reduced sufficiently, and the terms-of-trade shock abates somewhat, the real exchange rate need not depreciate that much, and may even end up appreciating a bit. This is overshooting on steroids: a very sharp initial loss of value for the domestic currency, followed by a gain that may leave the exchange rate, measured in inflation-adjusted terms, stronger than it was at the start.
 
For many emerging-market economies, this is, alas, a painfully realistic scenario. Since the subprime crisis, ultra-low interest rates in the rich world have caused emerging-market firms to borrow like never before. Some of the debt does not even appear in the official statistics of borrowing countries, because it was often taken on not by domestically-based firms, but by their offshore subsidiaries.
 
The Bank for International Settlements estimates outstanding dollar credit to non-bank borrowers outside the United States at $9 trillion. Big debtors include some of those countries whose currencies have come under downward pressure recently: China ($1 trillion), Brazil (more than $300 billion), India ($125 billion), plus Malaysia, South Africa, Turkey, and Latin America’s financially open economies: Colombia, Chile, Peru, and Mexico.
 
Central banks can intervene in the currency markets and sell reserves, thereby offsetting the withdrawal of financing by foreign lenders. But intervention requires that the authorities first have both the reserves and the will to abandon (at least temporarily) their hands-off commitment to a floating exchange rate. Not all emerging-market central banks are in a position to fulfill both of these requirements.
 
A sharp growth slowdown is the other component of this overshooting adjustment pattern. The initial export shock was likely to reduce growth. The sudden deleveraging imposed by foreign creditors requires the current-account balance to adjust further and faster.
 
The additional exports triggered by the depreciated currency can help, but they are often slow in coming. The fastest way to adjust is via reduced demand and imports, and that is what almost always ends up happening. Growth and job creation take the hit, as we are seeing today in emerging market economies around the world.
 
In these circumstances, currency traders suffer. But citizens of indebted middle-income countries are likely to suffer far more. Today’s emerging-market turmoil is here to stay, and they are the true victims.
 


Emerging markets turmoil: in charts

Robin Wigglesworth in New York

.
NEW YORK, NY - AUGUST 10: Traders work on the floor of the New York Stock Exchange during the afternoon of August 10, 2015 in New York City. The Dow Jones surged over 230 points after five days of losses. (Photo by Andrew Burton/Getty Images) *** BESTPIX ***


Turmoil across emerging markets has intensified during August and for many veteran fund managers, there is a very real concern that selling pressure will escalate and draw comparisons with past implosions, notably the emerging market crisis of 1998.

Here are some charts that show just how bad things have become in local equity and bond markets in the developing world.




This has obviously been building for some time, with concerns over individual developing countries such as Brazil and Russia, weaker commodity prices and US Federal Reserve interest rate increases on the horizon. But the trigger for the deepening rout is mounting concerns over China’s economy — a vital driver of emerging markets as a whole.

As the charts show, the Shanghai stock market has fallen precipitously this summer, and Beijing this month devalued its currency slightly, exacerbating fears over emerging markets.




Yet there are more profound, fundamental problems dogging emerging markets. As the four charts from Capital Economics show, economic growth, household consumption, industrial production and exports in the developing world have all slowed sharply in recent years.




Of course, emerging markets is a blunt concept, and not every country is in bad shape. Morgan Stanley analysts have made a list of the countries it sees as the most vulnerable, based on factors such as dependence on overseas funding, debts metrics, growth fundamentals and exposure to China.

Brazil, South Africa and Turkey look the worst, while Indonesia, Russia, Peru, Malaysia, Colombia and Mexico are also vulnerable. Morgan Stanley have also made a handy Venn diagram for further illumination.




Drilling down into two of these issues, here are two charts from Barclays and UBS respectively.

The first one from Barclays shows which countries are the most dependent on exports to China, while the second one from UBS underscores how there is still plenty of international investor money in emerging bond markets, despite a fierce shake-out in the 2013 “taper tantrum”.




That could mean that foreign inflows are stickier than expected, or that there is much more scope for pain if investors throw in the towel on emerging markets, as they have often done in the past.


Editorial

The Politics of Desperation

By THE EDITORIAL BOARD

If Greece’s European creditors think the resignation of Prime Minister Alexis Tsipras will improve their leverage over Athens, they best think again. First, there is no telling what the new wave of political tumult in the struggling nation will bring, and it is entirely possible that Mr. Tsipras will return as prime minister of a stronger coalition.
 
Endlessly lending Greece more money to pay off old debts helps neither Europe nor Greece, no matter who is running the country. As the International Monetary Fund has finally and publicly acknowledged, Greece can never repay its 300-billion-euro debt, and putting off a restructuring will only add to the agony of the Greeks, discord in the European Union and the likelihood of a Greek default.
 
Given that his scant seven months in office were one continuing crisis, it is hard to judge how good a prime minister Mr. Tsipras was or could have been. A hard-core leftist, he promised things he could never deliver, like abandoning the austerity regime that has pushed Greece into a depression. He tried everything to sway the creditors — brinkmanship, bombast and a snap referendum on July 5, in which 61.3 percent of Greeks voted to reject the terms of the latest bailout. None of that worked, and in the end Mr. Tsipras was forced to accept the latest terms.
 
The resulting defection of the radical wing of his Syriza party left Mr. Tsipras with no choice but to seek new elections. That is not easy in Greece, since other major parties must be given a chance to form a government after a prime minister resigns. But the current political arithmetic makes a new election, possibly as early as Sept. 20, all but inescapable.
 
For all his failings and failures, Mr. Tsipras remains the most popular political figure in Greece, because a large part of the population accepts that he did his best to improve Greece’s lot. How that plays out in elections is to be seen. The other major parties, New Democracy and Pasok, are in the midst of leadership struggles, and the breakaway faction of Syriza, now called Popular Unity, is small.
 
Whether Mr. Tsipras returns or not, the next government will have to do more to make the country more productive, and that includes many of the reforms European leaders have demanded — cutting pensions, streamlining regulations, privatizing state-owned businesses. But it is hard to see how even the most effective and popular government can do these things if the country remains trapped in a whirlpool of debt.


Markets Storm Leaves Euro High and Dry

The euro’s strength will cause new problems for the eurozone economy and European Central Bank.

By Richard Barley

The European Central Bank’s headquarters in Frankfurt. The European Central Bank’s headquarters in Frankfurt. Photo: Agence France-Presse/Getty Images


As global markets spiral lower, investors are seeking safety. The euro, a currency whose political integrity was in question only six weeks ago, is a clear winner. That presents a headache for the eurozone.

The euro on Monday briefly hit $1.17, its highest against the U.S. dollar since January. Less than a week ago the single currency was close to $1.10. On a trade-weighted basis, the euro is now at its strongest since the European Central Bank announced its bond-purchase scheme in January, data from the central bank show.

In part, the rise in the euro is the result of investors scaling back expectations of an increase in U.S. interest rates. The gap between U.S. and German two-year bond yields has contracted sharply in recent days, undermining the dollar’s appeal. German two-year yields, at -0.28%, are already extraordinarily low.



So, the more the U.S. bond market worries about growth and the ability of the Federal Reserve to increase rates, the more the gap is likely to be squeezed. That will add further support to the euro.

Even more powerful at present are technical forces. The euro’s low-yielding status, with big chunks of the eurozone government bond market offering negative yields, has turned it into a so-called funding currency. In this, it is like the Japanese yen, a currency in which it is attractive to borrow to fund risky bets elsewhere.         

As risk aversion and volatility rises, however, investors may be forced to abandon those wagers and buy back the euros they sold to fund them. One signal that this is happening is the negative correlation between stock markets and the euro: on days where stocks sink, the euro rises, and vice versa.

Monday’s 5.3% drop in the Stoxx Europe 600 was accompanied by a jump of than 1.5% in the euro against the dollar. There is also a feedback loop at work in Europe: a weaker euro was one of the forces propelling stocks higher as investors hoped the currency’s decline would boost European earnings and growth.

Taken together, this is a real challenge for the ECB, which has bet on a weaker euro as a way to boost eurozone inflation. The rise in the euro’s trade-weighted value, in particular, is a sign of a new component to the problem: the depreciation of the Chinese yuan and its ripple effect across emerging-market foreign-exchange rates. As long as the yuan was stable against the dollar, this was a force that could help weaken the euro; this now can’t be relied upon.

Some market participants think the ECB’s September meeting could be a possible venue for some kind of step up in the central bank’s efforts to boost inflation, perhaps by indicating it might reinforce its bond purchases. But given the low level of eurozone yields, even that probably wouldn’t have as much impact on the euro as a reduction in risk aversion—most likely through policy actions in emerging markets, particularly China—or signals the Fed is still pushing to increase rates.

The political survival of the euro was a victory for the ECB. Its newfound attractiveness to global investors will provide much less reason for cheer.