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EM Currencies Set to Trade Lower Still Following Chinese Roller-Coaster?

The global financial
markets have been on something of a roller-coaster ride recently following the
events in China.

There has been a
sudden decline in the onshore Chinese equity market, a subsequent sharp
depreciation in commodity markets and the People’s Bank of China (PBoC)
deciding to adjust the CNY fixing mechanism, which prompted a 3% decline in the
CNY.

All of this comes at a
time when China appeared to be implementing a string of policy measures aimed
at easing financial conditions and shoring up growth, the most obvious example
of this being the PBoC rate cut earlier this week.

Nowhere has the impact
of these changes been felt more keenly than in the emerging markets, after a
flight to safety from investors left the value of EM currencies tumbling.

This is not the first
time in recent history though that there has been a sharp EM currency sell-off.
In both 2013 and 2014 emerging market currencies endured sharp declines, in
both cases largely due to fears about anticipated changes in US monetary
policy.

So is the latest
decline in the value of EM currencies any different?

Peter Kinsella, head
of emerging market economic and FX research at Commerzbank in London, argues
that it is.

“The first thing to
note is that if you look at the gains or losses, particularly the losses
year-to-date for EM currencies, they’re actually far more severe than what we
experienced during the immediate aftermath of the so-called “taper tantrum”. So
what we’re seeing now is definitely a bit more aggressive,” he says.

“Cocktail” of Economic Pressures

Naomi Fink, CEO of
founder of Europacifica Consulting in Australia, also notes that this latest EM
crisis has its roots not in fears of a specific crisis event, but in broader
fears of a slowdown in Chinese demand.

“The fear is now not
only that China will slow to stall speed but that it will also export deflation
to the rest of the world, which for some economies who are desperately
attempting to reflate – Japan, for example 
and parts of the Eurozone, could spell disaster for central banks’
reflation goals,” she says.

Jesus Gustavo
Garza-Garcia, chief Mexico economist at Itau BBA, agrees that this latest
flight from EM currencies is different to previous occasions, and suggests that
the downward pressure is being caused by “a cocktail of three things”.

The first factor he
cites is the anticipation of a strong USD caused by the normalisation of
monetary policy in the US. The second is the price of oil, with crude oil
moving from $40/bbl to $60/bbl and back again over the last six months, which
has had a significant impact for oil dependent economies. The third is the
devaluation of the yuan in China, which is pushing commodity prices downwards.

When considering the
capital outflows from EM economies, however, Garza-Garcia argues that it is
import to distinguish between different types of EM economies. For example,
because 80% of Mexico’s exports go to the US it is much more linked to what is
happening in that economy than China.

“Additionally, I would
say that Mexico has an advantage over commodity-based Latin American economies
such as Chile and Brazil because it is more of a manufacturing economy,” he
says. “In Mexico the fiscal account and macro economic fundamentals are solid
and it has had structural changes to help improve the economy. In contrast,
Brazil is in urgent need of economic reform and Colombia is heavily dependent
on oil and doesn’t hedge like Mexico does.

“Therefore I would
differentiate the impact of what is happening in China on EM economies based on
the macro-economic fundamentals, the medium-to-long-term growth prospects and
the structural reforms that they have undertaken,” he adds.

Reality check

Alberto Dwek, an
independent economist in Sao Paulo describes the situation in China as a “long
overdue reality check” that it likely to have particularly heavy repercussions
for Brazil.

“A weaker yuan, and
especially the economic reasons behind it, bodes extremely ill for what we can
only call the moment of reckoning for Brazil and its South American
companions,” he says. “In Brazil’s case, given the paradise promised to the
masses, the impact will be much heavier. Dollar rates in the 4-4.5 range will
exact a heavy toll through inflated prices, and real interest rates close to 8%
some time next year will be more nails on the coffin of an economy already
battered by the life-sucking vampirism of all-powerful tax collectors at the
helm of a bloated ship whose first-class passengers think only of their
champagne and caviar.”

With the return of a
stronger dollar Dwek predicts the return of “the old equilibrium where well
managed democracies with strong controls and public governance fare better than
profligate, disorganised and inefficient governments with a centralised,
bureaucratic management, regardless of such treacherous competitive advantages
as a low-cost workforce or abundant deep-sea oil”.

Given its reliance on
oil and trade ties to China, it initially appears somewhat surprising that
Russia has not suffered more as a result of the fluctuation in the yuan and
expectation of a Chinese slowdown. According to Kinsella, the reason for this
is the current account surplus of Russia and the central bank’s interventions
in the market thus far this year.

“If they ran a
currency account deficit, you’d be hearing a lot more about Russia right now,”
he says. “The ruble is trading at around 66 to the dollar right now and the
central bank there has done all of the right things. Earlier on in the year
they hiked rates aggressively when they had to, they cut them recently and have
gone on a bit of a rates cutting cycle, they’re trying to rebuild their
reserves in recent weeks and so have been doing all of the right things.

“We don’t hear as much
about the ruble at present but it still has vulnerabilities. Like with other EM
currencies, it’s a terms of trade story, they’re seeing a decline in their main
and really only export. I think you can see that in a broader sense in EM if you
take out the commodity story, there’s not really an awful lot going on in these
markets,” Kinsella adds.

Pressure on Asian Bloc

In Asia, Richard Earl
at payment and risk management firm, AFEX, says he’s not convinced that China
won’t devalue its currency further this year and predicts continued downward
pressure on many of the Asian block currencies. He points to the
devaluation of the dong in Vietnam and the floatation of the tenge in
Kazakhstan
– which subsequently lost almost 25% of its value – as evidence
of this.

“For these countries
to compete they’re going to have to deal with weaker currencies just to steal
some of that export business, but for the more developed countries the real
risk is if this currency war intensifies down the road it will import deflation
into the US,” he says.

Despite the pressure
that some Asian currencies are under right now, in the longer-term Fink notes
that the “new normal” in China is likely to mean that Asian regionals with
consumer-oriented exports will fare much better than emerging commodity
producers.

“Assuming China’s
demand slowdown does not result in a full-blown crisis, Asian producers of
intermediate and consumer goods might show much more resilience than their
commodity-producing counterparts,” she says. “This is not to say that pockets
of extended leverage will not adjust; aggregate economies as a whole in Asia
may see select business failures and smaller current account surpluses as China
slows, but weaker currencies might actually assist in enhancing export competitiveness for these economies in the long-run.

“Comparatively, given
the policy shift toward slower investment versus consumption, the same may
/not/ be true for commodity producing emerging markets,” she adds.

Too Early for Bargains

Overall, the recent
events in China have had a strong negative impact on the value of EM
currencies, and although in some cases the value of these currencies might seem
artificially depressed, Kinsella warns that they might well trade lower still.

“Some people will say
there’s good value in EM at the moment, given the very aggressive sell-off, the
fact that equities are cheap on a PE ratio and that EM currencies should be
cheap, but that doesn’t see the wood for the trees,” he observes. “Valuing EM
assets in a generic sense is always a bit tricky because you have to add in a
risk premium because of issue like political risk. That’s why EM equities trade
with lower price ratios. But structurally higher interest rates in places like
Brazil and Turkey, where they’ve had to hike to protect their currencies, means
that those earnings won’t be as good in the next year or two.

“When you have volatility
like you have at the moment, it’s a little bit early for going bottom fishing
looking for bargains,” he concludes.

galen@profit-loss.com            Twitter: @galen_Stops 

Colin Lambert

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