Emerging Risks
Currencies of developing countries have been strong. Here's what may come next.
By ENDA CURRAN
Emerging-market currencies have paid off for many investors lately. But analysts warn that investors shouldn't be lulled into thinking the good times will necessarily last.
Robert Neubecker
On the upside, rapid economic expansion in developing countries should continue to bolster their currencies—good news for investors in stocks and bonds from those countries.
Many countries, though, are fighting the appreciation of their currencies, mainly because it makes their exports less competitive and encourages imports that compete with domestic products. Some have imposed restrictions on capital flows, and others have sold their own currencies in the foreign-exchange markets.
How serious developing countries are in those efforts will go a long way toward determining how their currencies fare over the long run.
"Even with the capital controls, I don't think you are going to be able to stem the overall appreciation trend," says New York-based Joyce Chang, J.P. Morgan & Co.'s global head of credit and emerging-markets research. "But we're not expecting the same kinds of returns that were achieved in 2010," she says.
Ms. Chang expects gains of 5% to 8% in emerging-market fixed-income securities this year, compared with returns of 12% to 13% in 2010.
In general, analysts look for gains in the Korean won, Singaporean dollar, Russian ruble, Mexican peso and Philippine peso as robust economic growth and higher interest rates spur capital inflows. Currencies under pressure include the Israeli shekel, given security concerns in the region.
Big Shifts Ahead?
The long-term appeal of emerging-market currencies stems in part from imbalances in global investment flows, which suggest big shifts are still to come. For example, emerging-market economies make up 29% of the world economy, according to HSBC Holdings PLC, but U.S. pension funds have only about 6% of their assets in emerging-market equities.
Meanwhile, as confidence in emerging markets has grown, governments and corporate borrowers in those countries have increasingly issued debt in their own currencies. A total of $437.7 billion of such debt was issued last year, down slightly from $452.7 billion in 2009 but 52% more than in 2008 and nearly triple the amount issued in 2005, according to Dealogic. The improved liquidity in these markets should, over time, attract a growing number of foreign investors, further buttressing the local currencies.
More immediately, demand for some emerging-market assets is likely to get a boost as the credit ratings of several countries are upgraded to reflect improved government finances, among other things. In January, the Moody's Investors Service unit of Moody's Corp. raised Indonesia's local- and foreign-currency debt ratings one notch to Ba1, a single step below investment grade, citing the country's resilient economy, improving debt and foreign-reserve levels, and favorable economic policy. Analysts cite the Philippines and Sri Lanka as likely candidates for upgrades.
And on a broader scale, current interest-rate trends favor emerging-market investments, as the big industrial countries keep their rates low to encourage economic growth.
"Very low rates in the developed world for an extended period of time" will push bond managers toward markets with higher interest rates and the potential for currency appreciation, says Ashish Agrawal, fixed-income strategist for non-Japan Asia at Credit Suisse Group.
Central banks in many developing countries, where interest rates are higher, have tried to keep those rates from climbing further, to prevent their currencies from appreciating too much. But it will become clearer this year that those central banks need to allow interest rates to rise in order to control inflation as their economies surge ahead, says Richard Yetsenga, head of emerging-markets currency strategy at HSBC.
The Risks
To be sure, there are potential pitfalls for any bet on emerging-market currencies. One longstanding concern is the possibility that instability in places like the Middle East or the Korean peninsula will drive funds toward safer currencies like the dollar or the yen. Another worry is the prospect of quicker-than-anticipated economic growth in the U.S. and Europe, which could draw funds back to the developed world.
Given the risks, some investors might be tempted to cash out of their successful emerging-market holdings, says Olgay Buyukkayali, the London-based head of strategy for emerging Europe, Middle East and Africa at the Nomura Securities unit of Nomura Holdings Inc.
If the spread shrinks between the yields of emerging-market debt securities and the lower yields of bonds from industrialized countries, says Mr. Buyukkayali, "I think we will see a degree of profit-taking" in emerging-market debt by bond-fund managers.
Mr. Curran is a reporter for Dow Jones Newswires and The Wall Street Journal in Sydney. He can be reached at enda.curran@dowjones.com.
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