Summary and Conclusions

Most EM currencies are in jeopardy.  Despite the sharp sell-off we have seen so far in some crosses, our view is that we are only in the second inning of this powerful process that will likely last well into 2009.  So far, capital outflows by local investors may have been the key driving force behind the EM currency weakness.  But as the global economy slows in the coming quarters, capital inflows from non-EM economies will likely decline sharply, depressing EM currencies even further.  While differentiation between EM economies based on their economic fundamentals will obviously be a part of the thought process for investors, we believe, in this cycle, contagion will be much more powerful and will overwhelm much of the differences in the economic fundamentals between countries.  In other words, countries with seemingly positive economic fundamentals could very well see their currencies plummet as sharply as those without good fundamentals.  We remain very worried about the EM currencies and expect there to be adverse implications from this EM currency sell-off for their economic fundamentals. 

Sharply Slower Global Growth in 2009

On our current forecasts, the world is heading into a synchronous recession in 2009.  Our own guess is that risks to growth are biased to the downside for the EM economies, relative to our forecasts.  As the global economic slowdown materializes in earnest, the EM currency sell-off we envisage will likely go through several phases. 

•           Step 1.  The dollar experiences a broad-based risk-aversion induced rally.  This process began in May this year, and will likely continue.  According to our Dollar Smile Framework, whenever the US enters a deep slow-patch, the dollar actually strengthens as safe-haven flows into US bond markets keep the dollar strong.  The intensifying financial crisis will likely accentuate the cross-border unwinding of risk.  Since the world has been shorting dollar for much of the past six years, it will take a while longer before the currency markets find a new equilibrium for the dollar.  As a result, most EM currencies will likely weaken relative to a strong dollar. 

•           Step 2.  Exchange rate expectations in EM economies are grudgingly altered, and hedging strategies revised.   The move higher in the dollar will, and in some cases has already, set off a chain reaction.  After an initial phase of denial, domestic agents (exporters, importers, and investors) will need to realign their hedging strategies with the new expected path of the exchange rate.  In our view, the adjustment of hedging strategies by local economic agents has been the single-most powerful driver behind the recent weakness in KRW, INR, BRL, and MXN. 

For countries that have experienced persistent currency strength in recent years, it is likely that the exporters are over-hedged (i.e., bought the local currency at the earliest opportunity for both the carry and the expectation that it will strengthen over time) and importers are under-hedged (i.e., sold the local currency at the latest opportunity).  My colleagues covering Latin America have highlighted complicated structures that treasurers of corporations have entered to take advantage of the powerful appreciation trends in these currencies.  But many other countries have similar issues, that the local corporates are either under- or over-hedged, and a change in the direction of the exchange rate has (or will) trigger a flurry of unwinding of these positions. 

We illustrate our simple calculation of how serious this problem might be in various countries.  Assuming that the general expectation of how the currency will perform in the coming year is a function of its performance in recent years, with the most recent year’s performance having the highest weight, we calculated that, in Brazil, the Philippines, Poland, Slovakia, Czech Republic and Turkey, this problem may be more intense than elsewhere.  (Of course, the Eastern European economies are on a structural convergence path towards EUR adoption; the danger here is only for hedging positions against the USD.)   After an intense trend appreciation of the BRL since 2004 by more than 100%, it is more likely than not that the locals are heavily skewed in their hedging positions.  The high interest rates in Brazil also suggests that these ‘implicit carry trades’ are likely to be deep and well-populated.  The same may apply to Turkey, and all the other countries high in the chart.  For MXN, while expected appreciation may not be nearly as intense and one-way as for BRL, the interest rate premium may have exaggerated the ‘implicit carry trades’ to leave Mexican exporters and importers in an equally out-of-balance hedging position. 

There are several implications of this domestic hedging story.  First, the impact of the unwind of these positions could be rather violent, as suggested by the recent performance of INR, KRW, BRL and MXN.  Second, the strength of the pushback from the local investors to the idea that the dollar could strengthen further is, to us, an informal proxy for how big this problem is.  For example, in the past weeks, our call on USD/BRL has been met with the fiercest pushback, which we actually found alarming.  Third, this process of positioning unwind has nothing to do with the economic fundamentals of the country in question.  Thus, investors should not be fixated on the ‘need to differentiate’ between countries’ fundamentals in thinking about currency risks. 

•           Step 3.  Carry trades to be unwound.  The altered path of expected currency movements will eventually undermine the confidence of foreign institutional funds that have carry positions, which we suspect to still be extremely large.  The EM currencies that carry high yields and with good market liquidity could be very vulnerable to a simultaneous sell-off as overseas institutional funds unwind their carry positions.  Here are some of the high-yield EM currencies (their 3M interest rates in parentheses):  IDR (33%); TRY (18%), ISK (16%), INR (16%), PHP (14%), BRL (13%) and ZAR (12%).  Again, the relative economic fundamentals matter less in this process of positioning unwind.  We are, in fact, very bearish on all of the above-mentioned currencies. 

•           Step 4.  Other types of capital inflows to abate sharply in 2009.  What we have discussed so far are dynamics that will likely take place in the near future, originating mainly from the local investors’ behaviours and what some foreign investors might do with their legacy investment positions.  However, what is at least as worrying for these EM currencies is that, in 2009, new capital inflows will likely dwindle.  In some recent notes (On the Vulnerability of EM Currencies (October 2, 2008), Capital Flows and the BRIC Currencies (September 26, 2008) and Risks of a Sharp Reduction in Capital Flows to EM (September 26, 2008)), we warned that gross capital flows into EM, which surged from an average of around US$550 billion a year during 2005-06 to US$750 billion a year in 2007-08, could fall to US$550 billion in 2009.  In light of the sharp deterioration in global financial conditions and our new global growth forecasts published on October 6, it now looks likely that 2009 may only see US$400-450 billion of flows into EM.  This dramatic slowdown will likely expose the structural problems that many EM economies have, and will stress-test the thesis that EM performance in recent years has not benefitted from the credit bubble. 

Need for Differentiation, and Contagion Factor

We believe the need for differentiation is important, but often exaggerated, particularly in times of intense market pressures.  The EM economies with relatively good economic fundamentals (such as Brazil and India) will not avoid seeing their currencies weaken sharply, as they indeed have.  In Steps 1-3 listed above, contagion is likely to be the dominant force, that the economic fundamentals will, at most, determine the magnitude of the currency depreciation but will not prevent such a depreciation.  The need to differentiate among EMs, however, might become more important in Step 4. 

Interventions Will Not be Trend-Reversing

The global forces triggering the sell-off in EM currencies are immensely powerful.  We do not believe that currency interventions will be successful at reversing trends, though they may contain the pace of the currency sell-off. 

A Global EM Currency ‘Moment’, in Contrast to History

All of the currency crises in modern history have been regional.  However, we believe many EM currencies in different parts of the world could experience intense pressures in the months ahead, in contrast to the historical norm, i.e., the EM currency ‘moment’ will be global, not regional.

Bottom Line

We remain very worried about most EM currencies and believe that the violent sell-offs in some EM currencies in recent weeks mark only the beginning of what is likely to be a multi-month process.