FX Monthly – EM FX…no crisis this time

by: Georgette Boele

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EM currencies have taken a turn for the worse

Our new currency indices show significant drops in EM currencies against the dollar since the start of May, led by Latin America and emerging Europe, but with Asian currencies proving more resilient. This reflects disappointing economic data, the decline in commodity prices and the rise of political unrest in a number of countries. At the same time the outlook for the US economy has been improving and the build-up of Fed exit expectations led to the unwinding of carry trades that had supported emerging market currencies and bonds, as well as a general deterioration in investor sentiment.

No EM currency crisis but headwinds

The current episode has some similarities to EM crisis periods. For instance rising US interest rates, an improving US economy and falling commodity prices. However, there are also major differences. In particular, emerging market fundaments look much healthier than in the past. First, even though most emerging market have debt outstanding in dollars or other hard currency, these debt levels are manageable. Second, these countries have in most cases adopted ‘semi-floating rate’ regimes. Even though we have downgraded our emerging market GDP growth forecasts it’s certainly not all doom and gloom. We expect the global economy to strengthen in the coming quarters, which will support EM exports. Stronger global growth should also underpin investor sentiment and provide support to currencies that have been aggressively sold-off (ZAR, BRL) and/or that have strong fundamentals (MXN). Overall, although there are certainly headwinds and risks for EM currencies, a crisis looks unlikely.

Implication for our forecasts

We have modestly downgraded our emerging market currency forecasts. We still expect a recovery in EM currencies in the near-term on the back of a US-led strengthening in the global economy and improving investor sentiment. However, we expect emerging market currencies to soften against the dollar in the second half of 2014, once the Fed’s rate hike cycle – which we expect to begin in Q1 2015 – comes into view. Asian FX – especially the CNY – will likely to be the most resilient, as well as currencies with a strong US link (MXN). Countries of currencies with robust domestic demand and the central bank tightening will also fare well.