By John Taylor, FX Concepts
Currency is the simplest expression of a country. As systemic risk tipped one emerging currency after another into devaluation last year, 1998 saw the appearance of a regional hard currency in the form of the Polish zloty.
Despite floods, financial storms and economic woes to East and West, Poland gained a reputation as a safe haven. That perception temporarily lifted the zloty into a new class of asset and gave the National Bank of Poland a tough job protecting its money supply from the ardent advances of investors rushing in to capitalise on the substantial interest return the zloty afforded.
There is currency risk investing in the zloty, but there are also high interest rates. This is Poland’s risk-free return: the carry earned by investing in short-term deposits or in forward contracts.
Historically, currency has been the dominant factor in emerging markets returns. The development of the swaps and non-deliverable forwards markets in the ’80s and ’90s, respectively, has further eased one of the greatest drawbacks to emerging markets investing – the question of liquidity.
The legislation that Poland introduced at the start of this year formalised a practice already in place of gaining access to the zloty market by means of a currency swap with a local bank. The currency swap enables the investor to profit from the interest rate differential while protecting the investor from adverse moves in the spot, or being stuck with a currency that one cannot sell when liquidity dries up, as happens when a country tailspins into crisis.
For the portfolio investor in emerging markets, the question of country return is paramount. Picking the right country is critical. Currency investing is the ultimate in top-down investing; in fact, it is nothing but country picking. The interest rate, plus the depreciation – or the appreciation – of the currency, equals the return.
For emerging market investing, the portfolio is structurally long emerging markets currencies. Unfortunately, what one gains on the interest rate can be wiped out by a collapse in the spot. How then to determine when to be in, or when to be out?
The basis of our philsophy is that markets repeat themselves. History does tell you something. There is method to what sometimes can appear to be madness in the market, indeed in all human endeavour. There is a rythm to the peaks and troughs of a market. Cyclical analysis is the study of the rise and fall of economies, and Poland’s is on the rise.
is chairman of New York-based FX Concepts, a foreign exchange research and management company. FX Concepts launched its research service for Emerging Markets Currencies in 1997, and shortly afterwards, began a dedicated Emerging Markets fund.