EM FX Weekly – Brazilian real outlook deteriorates

by: Roy Teo , Marijke Zewuster , Peter de Bruin

  • Emerging market currencies lower
  • BRL impacted by worsening fiscal situation and negative S&P outlook
  • RUB under pressure on the back of lower oil prices
  • CNY: Depreciation undercurrents building





Emerging market currencies lower

Emerging market currencies closed lower in the past week due to weaker commodity prices and concerns of capital outflows as tighter monetary policy in the US nears. The Russian ruble (RUB) and the Brazilian real (BRL) were among the worst performers, each sliding by about 3% in the past week.


BRL could weaken further

The recent further weakening of the BRL reflects worries about fiscal consolidation and the fear that Brazil might lose its investment grade rating. The government last week revised the primary surplus target for 2015 from 1.1% of GDP to only 0.2% and the 2016 target from 2% to 0.7%. Although very few believed that the previous targets were feasible, the strong reduction did come as an unpleasant surprise. Fiscal adjustment is key for Brazil to maintain its investment grade rating. The deterioration in the fiscal outlook was therefore the main reason for S&P to announce  a negative outlook, while confirming the BBB- rating. Moody’s and Fitch have a negative outlook, but their rating is still two notches above junk status. While all recent economic data point to a deepening of the recession in the second quarter, inflation continues to rise, reaching 8.9% yoy in June. The recent increase of the Selic rate by 50bp to 14.25% on 29 June therefore was in line with market expectations. The Copom signalled that the intention is to keep the Selic at 14.25% for a prolonged period from here on. However as it is difficult to see how Brazil will get out of the vicious circle of a deepening recession, a worsening fiscal situation and higher inflation, the BRL will remain under pressure. Another rate hike is therefore still possible.


Russian ruble slides on oil

The slide in the RUB reflected the drop in oil prices that we have seen over the past days. The drop in the RUB brings back memories of the financial instability that we saw in December of last year and has prompted the authorities to take a more cautious stance. For instance, while we think that the CBR will soon start to buy foreign FX again, it has paused its daily FX purchases. We also think that the central bank will cut its key rate at a gentler pace than earlier this year at this Friday’s meeting. But the bigger picture will be that falling inflation and a weak economy will keep the CBR in a loosening mode. We therefore continue to think that the CBR’s key rate will be heading to 9% at the end of the year.


CNY: Depreciation undercurrents building

The offshore non-deliverable forward market (CNY NDFs are cash settled against the daily yuan fix) implies that the yuan fixing will remain stable this year, as the authorities seek a stable currency ahead of the IMF review to include the yuan in the SDR basket. We maintain our view that a weaker Chinese yuan is needed to support and inflate the economy. The strong yuan and uneven pace of global recovery have pressured profits of both state owned and private industrial enterprises. Various data also suggest that the central bank intervened in the currency market to stabilize the yuan in June as capital outflows continued. As authorities have indicated that a more flexible exchange rate regime is likely in the coming months, investors are gradually positioning for a weaker yuan. This is evident as both the offshore and onshore yuan deliverable forwards have been rising since early June as investors speculate and hedge against future yuan depreciation. The options market demand to hedge weakness in the yuan has also increased. We expect the yuan to decline towards 6.30 against the US dollar this year as the yuan is expected to remain on the weaker side of the yuan trading band when the latter is further liberalised (from current +/-2% to +/-3%).