Feb 3: Carry on trading
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Emerging Markets

Feb 3: Carry on trading

It feels like 2010 again: an EM currency rally, US angst over Chinese currency policy, and global 'currency war' fears

FX fever returned with a vengeance this week across emerging markets, with a number of popularly traded EM currencies posting significant gains. As of midday Friday, London time, the South African rand was up 3.1% since the start of the week, the Turkish lira was up 2.1% and the Brazilian real and the Mexican peso were both up 1.4%. This trend was seen across emerging market regions and currencies – the MSCI EM Currency Index was up at the close of trading on Thursday 1.3%. Year-to-date, the index is up 4.3%.

Judging from the tone of reports clogging up our inboxes this week, a cosy sell-side consensus has formed that emerging markets currencies can maintain this upward bias for some time yet given strong liquidity conditions as well as receding concerns of a Chinese hard landing and immediate eurozone implosion.


Expectations of further liquidity operations by the US Federal Reserve and the European Central Bank have only served to fuel expectations that the rally has legs.

But before jumping on the bandwagon, it pays to be aware of the complex macro and policy dynamicsthat could spoil the party.

Following the previous bout of sustained EM FX appreciation, many policymakers introduced measures and controls in a bid to dampen the surging value of their currencies and maintain export competitiveness. To date, policymakers appear to be demonstrating a greater tolerance for moderate currency appreciation and foreign inflows. This appears especially true in economies still battling to tame sticky inflation – such as Turkey and India.

But this situation may not last. Brazilian policymakers in particular have been making loud noises about the damaging effects of further appreciation of the already overvalued real on the country’s struggling export sector, fuelling expectations that they may choose to intervene should the real continue to appreciate. In other words, the global currency war may soon rage, once more.


In addition, expectations that a second round of the ECB’s LTRO and QE3may unleash another flood of liquidity may prompt EM policymakers to build up their flood defenses. Furthermore, a number of less-consensual analysts, most notably Citigroup’s David Lubin, argue that with many EM central bankers now more focused on growth than inflation, they may decide that excessive FX appreciation would do unacceptable damage to real economic activity, and enact currency controls accordingly.


Sino-push

In many respects, all roads lead to China, by default. In a sense, China’s closed capital account and undervalued currency encourages capital flows to be diverted to regional peers, hiking regional currency appreciation pressures and potentially, bringing beggar-thy-neighbour capital controls to the fore. As Korn Chatikavanij, Thailand’s former finance minister, told us in the middle of the QE blitz of September 2010: “There is an element of the Asian currencies being used as proxies for the renminbi, because the renminbi is not internationalized. That is problematic in itself. If the renminbi were to be internationalized, then I think our currency problems would become more normalized." 

But the RMB controversy continues to rage. Almost alone among major EM currencies, the renminbi has actually weakened slightly against the dollar so far this year, raising the heckles of US politicians who are determined to make China’s undervalued currency a major election issue. While the RMB has reversed this trend slightly this week, with China’s president-in-waiting Xi Jinping due to visit Washington later this month and election fever heating up, China’s currency is sure to dominate headlines, even though, over the past year, the currency has appreciated, a development not lost on the IMF.

The jury is out. Are we staring at a repeat of 2010, when fears of currency wars and competitive devaluations dominated global discussions at the IMF and G20? In an environment of weak growth and significant downside risks, a resumption of currency and trade hostilities could be extremely damaging.

Or will we look back wistfully on this FX rally in six months’ time as a brief respite from the gathering storm, when the dark clouds that had shrouded markets throughout the second half of 2011 temporarily lifted, only to return with a vengeance as eurozone woes and slowing growth in the US and China quickly extinguished the optimism? Perhaps only Merkel and ECB know.

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