Forex Blog: Currency Trading News & Analysis.

November 23rd 2010

Emerging Market Currencies Still Have Room to Rise

Emerging market economies must be whining about their currencies for a good reason. Why else would they spend billions intervening in forex markets and risk provoking a global trade war?

Emerging Market Currencies Chart 2009-2010
As it turns out, however, the rise in emerging market currencies has been greatly exaggerated. Over the last twelve months, the Brazilian Real is flat against the Dollar. The Korean Won has risen a mere 2%. The Indian Rupee has risen 4%, the Mexican Peso has appreciated 5%, and the standout of emerging markets – the Thai Baht – has notched a solid 10%. Impressive, but hardly enough to raise eyebrows, and barely keeping pace with the S&P 500. Not to mention that if you measure their returns against stronger currencies (i.e. not the Dollar) or on a trade-weighted basis, the performance of emerging market currencies in 2010 was actually pretty mediocre.

Perhaps that explains why so many analysts are still pretty bullish. Economic growth in emerging markets is showing no signs of abating: Standard Chartered Bank “expects emerging economies to account for 68 per cent of global growth by 2030 and forecasts China’s economy to expand at an annual average rate of 6.9 per cent over that period, even as the US and Europe grow at a much slower pace of 2.5 per cent.”

MSCI Emerging Markets Index 2007-2010

Stock prices (proxied by the MSCI Emerging Markets Index) and bond prices (proxied by the JP Morgan EMBI+ Index) are still rising. Moreover, as emerging market Central Banks (continue to) hike interest rates, returns on investment (and consequently, the attraction to investors) will rise further. In fact, if credit default swap spreads are any indication, the risk of default is perceived as being lowest in emerging market economies. That means that investors are being compensated for taking less risk with greater returns! It doesn’t hurt that – as Fed Chairman Ben Bernanke recently pointed out – investors are buoyed bu the belief that emerging market currencies will continue appreciating, providing an addition boost to returns.

It doesn’t look like the capital controls and other measures being adopted by emerging market economies will have a significant impact on slowing the inflow of foreign capital. Investors are already devising products to thwart the controls. So-called Global Bonds, for example, allow foreign investors to buy emerging market bonds without having to pay any special taxes, because they are settled in the home currency of the investor. Besides, investors with a long-term horizon can take solace that such taxes will become insignificant when allocated over a number of years.

Credit Default Swap Spreads - Emerging Markets Versus Industrialized Countries 2008-2010There are, however, reasons to be cautious, In the short-term, bad news and flare-ups in risk aversion invariably hit emerging market assets hardest. Regardless of what information can be gleaned from credit default spreads, the majority of investors still associate the US with safety and emerging markets with volatility. That’s why when news of Ireland’s financial troubles broke, emerging market currencies fell across the board, and the Dollar rallied.

In addition, rising interest rates could cause bond prices to fall, and stock-market valuations may not be supported by fundamentals: “Emerging markets on average recorded economic growth of about 4 percent over the past few years while companies only recorded profit growth half of that. In China over the past decade economic growth was about 10 percent, while company earnings growth was only about 2 percent.” There is also evidence that investors and companies from emerging market countries are taking advantage of their strong currencies to invest and buy abroad, reversing the flow of capital.

Personally, I am slightly bullish with regard to emerging market currencies. The figures I quoted at the beginning of this post make it clear that we are not yet in bubble territory. In addition, even if fundamentals in emerging markets are not quite as strong as foreign investors would like to believe, they are certainly a lot stronger than in industrialized economies. Regardless of if/when the currency war is resolved, the short-term prospects for emerging market currencies remain bright.

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Posted by Adam Kritzer | in Emerging Currencies, News | No Comments »

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