FX Watch – End of EM intervention?

by: Georgette Boele , Roy Teo

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  • Is a shift underway in currency intervention by emerging market central banks?
  • Central Bank of Russia only wants to use reserves in case of emergency…
  • …while rate hikes seems more appropriate for Brazil
  • But there is no change in trend yet…
  • …as the central bank of Czech Republic does not seem willing to change and…
  • …intervention by Asian central banks continues due to higher volatility and weakness in the yen

A shift underway in EM currency intervention?

Two major emerging market central banks appear to have changed their stance towards currency intervention over the last few weeks. Indeed, the Russian Central Bank and the Central Bank of Brazil have decided to pursue less currency intervention. Why is this? Could this be part of a new trend?

Central Bank of Russia only wants to use reserves in case of emergency…

A more flexible exchange rate regime has come into force in Russia. After aggressive interventions in the FX markets to stop the fall of the ruble, the central bank has adopted a new strategy. What is this new strategy? This has the following elements:

–       More exchange rate flexibility,

–       only exceptional currency interventions when needed,

–       higher benchmark official interest rates,

–       and limiting ruble liquidity.

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Despite the dire growth outlook, the Central Bank of Russia only wants to use its reserves in case of emergency. This implies that it must hike its policy rates in order to defend its currency. It is likely that higher benchmark rates will further depress growth. In the near-term the sentiment towards the Russian ruble remains negative and USD/RUB could reach 50 (just below 33 at the start of this year). However, if sanctions are not increased further and the central bank continues to lean against the trend, the ruble should start to regain its footing. We think that weakness in the ruble due to the recent events has overshot.

…while rate hikes seem more appropriate for Brazil…

Just after the second round of elections, the central bank of Brazil decided to surprisingly hike interest rates by 25bp to 11.25%. It also decided to reduce the rollover of FX swaps meaning less support for the Brazilian real. This is a signal that policy may be moving into the direction of more rate hikes to contain inflationary pressures instead of currency intervention. The central bank will probably hike interest rates towards 12% in 2015 to tame inflation. This will probably further hurt growth. However, such an increase may result in an improvement in investor sentiment.

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…but weakness in Brazilian real probably ahead

The policy of the central Bank may prevent the Brazilian real from weakening sharply. However, higher interest rates will depress dismal economic growth further. What will be crucial for the overall sentiment is if Dilma Rousseff is able to form a credible economic team that will gain confidence and is capable of dealing with fiscal imbalances as well as structural shortcomings. At the moment, rating agencies and investors are especially concerned about the fiscal outlook. A downgrade to sub investment grade is a risk.

No change in FX policy in Czech Republic yet…

Despite the changes in the regimes in Russia and Brazil, More FX flexibility is not part of a wider trend. For example, the Czech central bank has not signalled any change yet. In August last year, it decided to introduce a EUR/CZK level at 1.27 to prevent a stronger currency from impacting the growth outlook. This policy has been quite successful as inflation has picked up. This is in sharp contrast to Poland and Hungary where deflation is still the rule of the game. It is likely that the Czech central bank will keep this policy in place to further support economic growth. We expect the central bank to abandon the EUR/CZK peg in 2016 when growth is strong enough to handle a stronger Czech Koruna with rate hikes at a later stage.

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…and FX intervention by Asian central banks is also continuing…

Foreign currency reserves in several Asian central banks including India, Thailand, South Korea and Taiwan have declined in the past few months. Though this could be due to a decline in value of foreign reserve currencies such as the euro and Japanese yen value relative to the US dollar, we suspect that they have been in the market defending volatility in their currencies.

…because of uncertainty about monetary policy in the US…

Uncertainty surrounding the timing and pace of rate hikes by the US Federal Reserve has resulted in higher volatility among Asian currencies in the past few months. Though there has been no hard evidence that the central bank of Indonesia has been actively defending weakness in the rupiah, they have warned that they stand ready to act against volatility in the currency. We think that they would be defending weakness in the rupiah towards 12,300 versus the US dollar. Surprisingly, volatility in the Indian rupee has been relatively subdued compared to other Asian currencies. The decline in foreign currency reserves signals that the Reserve Bank of India may have been defending the 62 level as that they have previously stated a preferential rupee range of 58-62 against the USD.

…and weakness in the Japanese yen

Weakness in the Japanese yen has also triggered a reaction by Asian central banks. Since the Bank of Japan announced its first qualitative and quantitative easing programme on April 2013, the South Korean won has appreciated by more than 25% against the yen. This has resulted in concerns of loss of export competitiveness of South Korea’s exports given the country’s high export similarity with Japan. The Bank of Korea (BoK) has recently stated that the weak yen adds to downside risks to the economy and will take action if needed. We judge that the BoK has been actively selling the won since 31 October, when the BoJ increased monetary stimulus. This is because among emerging Asian currencies the won has underperformed the most against the US dollar and appreciated the least against the yen.

In addition, it is likely that the central bank of Taiwan may be now taking the same approach. This would be driven by the recent strength of the Taiwan dollar versus the Japanese yen, which is unfavourable for their exports. We expect that they keep a close eye on developments in the crosses TWD/JPY and KRW/JPY.

In the case of China, we think that the People’s Bank of China (PBoC) has allowed the Chinese yuan to be determined by market forces in recent months. However, it is highly likely that action will be taken by the PBoC should yuan movements become more volatile or if they judge that the level of currency is becoming misaligned with economic fundamentals.

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