The collapse of emerging market currencies may continue
Summary
Over the past few months, emerging market currencies have come under extreme pressure. A more hawkish Fed combined with deteriorating global growth prospects were the root causes of the selloff in the EM currency complex. Although we have a particularly pessimistic view of emerging market currencies, the depreciation has been more severe than expected. We expect this depreciation pressure to continue; however, we have always been asked “how much further depreciation can EM currencies sustain?”
To provide insight, we have updated our emerging market currency vulnerability framework and use the results to assess the extent of further depreciation. The results are compelling and suggest that underlying economic fundamentals and local politics are consistent with further weakness in most developing currencies. There are exceptions, however, and our framework suggests that the fundamentals are consistent with a modest rebound in the Chilean peso, while the political depreciation of the Colombian peso has likely run its course.
Emerging market currencies have become more vulnerable
As economists, our responsibilities are to proactively recognize where economic fundamentals and local politics are moving in less or more positive directions. Early identification of these developments can help us adjust our forecasts in a timely manner and recommend an appropriate course of action for clients exposed to these countries. Over the years, we have developed and refined tools to help us detect these developments. When analyzing emerging market currencies, especially when they have come under severe pressure as they have this year, we tend to update and use our emerging market vulnerability framework quite often. Our vulnerability framework gives us a forward-looking view of changing economies and politics and supports our efforts to be as early as possible in recognizing changing economic and political conditions. Our framework includes a one-year-ahead current account balance forecast and a forward-looking measure of where inflation-adjusted interest rate differentials with the U.S. might be 12 months out. In addition, we include foreign exchange reserve adequacy (import coverage) and overlay this data with forward-looking judgment, as well as a political risk indicator to which we also apply judgment if necessary. We add up these variables to get an overall idea of how local conditions will change in each developing country that we forecast. Currencies associated with eroding fundamentals and politics are generally more vulnerable and volatile, while currencies with stable politics and a relatively strong underlying economy may be better protected in an environment where risky assets perform particularly badly.
In our view, the markets are still in the risk aversion environment that has permeated the world this year. This overall risk reduction episode is also where our EM FX vulnerability framework works best. In this sense, we have updated our vulnerability analysis for Q3-2022 to assess if and where conditions are changing, and which currencies could be more or less sensitive. Our latest update reveals some interesting findings. Our framework suggests that conditions in most countries are stable relative to Q2-2022; however, Our analysis reveals that conditions in some emerging countries are changing such that currencies are becoming more vulnerable to market shocks. That much, the Russian ruble and the South African rand have become “highly vulnerable” currencies, while conditions in Thailand have deteriorated to the point where the baht is now a “moderately vulnerable” currency (Figure 1). Including Russia and South Africa, conditions in seven countries evolved in a way that is consistent with outsized depreciations of their respective currencies during a global risk aversion event. Including Thailand, ten currencies now fall into the moderately vulnerable segment, while only Israel and China have currencies that our framework identifies as not very vulnerable.
The ruble’s deterioration stems from a lower real interest rate differential with the United States. Given the recovery of the ruble due to capital controls and the downward trajectory of local inflation, the Central Bank of Russia (CBR) has started to reverse the emergency policy rate hikes of the beginning of the year. Over the past few months, the CBR has lowered its policy rate by 1,050 basis points to 9.50%. This aggressive easing comes against a backdrop of rising US policy rates and has reduced the ruble’s yield advantage against the US dollar. While a reduced real interest rate differential pushes the ruble towards the highly vulnerable segment, a reduced yield advantage of the ruble is combined with high political risk amid tensions with Western countries and the conflict in Ukraine. In addition, international sanctions restrict the CBR’s access to the majority of its foreign exchange reserves and severely limit the ability of Russia’s sovereign wealth fund to conduct transactions and generate liquidity. Historically, more than adequate foreign exchange reserves and a large sovereign wealth fund have served as pillars of support for the rouble; however, the limited cushions have raised Russia’s country risk profile and contribute to the ruble now being a very vulnerable currency. Currently, Russia’s current account surplus prevents the ruble from being the most vulnerable emerging market currency; however, a negative real interest rate differential due to diverging monetary policy paths between the CBR and the Fed, limited access to reserves and high political risk make the ruble highly susceptible to sharp depreciation in times of market stress. world markets.
For the South African Rand, we expect the current account surplus to turn into a deficit, causing the currency to move into the highly vulnerable segment. With the increased risk of a global recession, demand for commodities is expected to decline over the medium term. In fact, we have seen these dynamics play out over the past few weeks as copper prices have fallen and oil prices have fallen below $100 a barrel due to recession risks. Since South Africa is a major exporter of commodities, especially precious metals and agricultural products, a decline in demand is expected to lead to lower metal and agricultural prices over the medium term. As commodity prices decline, South Africa’s current account balance is expected to move from a surplus to a modest deficit. A current account deficit is likely to be accompanied by persistent high political risk resulting from weak governance controls and a lack of momentum to implement a much-needed reform agenda. Additionally, the South African Reserve Bank (SARB) has insufficient foreign exchange reserves and may struggle to defend the value of the rand in times of extreme volatility. The SARB is also expected to maintain only a small positive real interest rate differential versus the U.S. as policymakers have taken a more gradual approach to interest rate hikes relative to the Fed, while the local inflation should continue to rise. Overall, fragile fundamentals and high political risks have led the rand to return to a highly vulnerable currency susceptible to sharp depreciation in a global risk aversion scenario.
And in Thailand, the baht’s move to moderately vulnerable is driven by the fact that the currency is now associated with a negative real interest differential. Bank of Thailand (BOT) policymakers were an exception to the trend of higher interest rates. Despite inflation trending towards levels last seen during the 2008-2009 global financial crisis and the Asian financial crisis of the late 1990s, BOT policymakers have maintained the view according to which the current inflation is only temporary. Considering that price pressures are transitory, the BOT has resisted raising interest rates or engaging in operations consistent with tighter monetary policy. With local inflation surging, BOT policymakers on hold, and the Fed rapidly raising policy rates, real interest rate differentials have moved into negative territory and are now a source of potential pressure on the baht. Apart from the diverging monetary policy trajectories between the BOT and the Fed, the underlying fundamentals in Thailand are actually quite strong. The country is expected to maintain a healthy current account surplus of around 1.5% of GDP in 2023, while BOT foreign exchange reserves should remain adequate going forward. Politically, local protests have erupted in recent years in response to COVID-related lockdowns; however, the protests have done little to disrupt Thailand’s political structure, policy-making capabilities, or governance controls. In this sense, we believe that the political risk in Thailand is low and that political stability should serve as a source of support for the baht in times of stress in the global market. Overall, our framework identifies the economic and political mix in Thailand as consistent with a currency that may now come under more pressure than before.