Emerging market currencies to depreciate further

With all eyes focusing on the Federal Reserve's meeting this week, forecasters are relatively pessimistic over the longer-term outlook for currencies in emerging markets.

Ever since Federal Reserve Chairman Ben Bernanke spoke about the end of his policy of printing money – or quantitative easing (QE) – last month, investors in emerging markets have rushed to the exits, sparking a sharp increase in debt yields and the depreciation of various currencies.

As long as QE was expanding, central banks had projected "a sense of near total control," driving bond yields and volatility to historic lows, and compressing risk premiums, Michala Marcussen, global head of economics at Societe Generale, said in a webcast about the global economy.

But as the Fed's exit from QE draws nearer, high bond yields and higher volatility are making a return, Marcussen added.

She believes the real economy will be able to absorb the shock if major financial market turmoil is averted.

Based on the Fed's guidance that it would keep rates at their current near-zero level for as long as unemployment stays above 6.5% in the US and inflation is projected at no more than 2.5% for between one and two years ahead, Societe Generale's analysts forecast the first hike in rates in late 2015.

In terms of QE tapering, if the economy continues to cope well with the fiscal tightening taking place currently in the US, they expect the Fed to start shrinking its quantitative easing in the autumn of this year and conclude the programme altogether in the new year.

Emerging markets have relied on the "ample supply" of liquidity from developed markets' central banks to finance the expansion of domestically-oriented sectors in order to withstand the global slowdown, Themistoklis Fiotakis, senior economist at Goldman Sachs, said.

"While we think this was an appropriate policy for some, for others it has led to a build-up of significant imbalances," Fiotakis noted in a monthly analysis of the global foreign exchange market.

"The emerging markets bond and foreign exchange sell-off of the last month is likely to constitute only a small part of a bigger trend for emerging market assets," he added.

WEAKEST AND STRONGEST

But the depreciation of currencies and the sell-off in bonds is likely to play out over the medium term, rather than the short term, according to Fiotakis. 

He looked at various indicators such as the external balance, share of domestic consumption to gross domestic product, net external liabilities and real exchange rates to gauge which are the countries most vulnerable to the reversal of flows.

When looking at the external balance, South Africa, Turkey, India, Brazil and Chile "have the most vulnerable external balances, both from a historical and a cross-sectional perspective," Fiotakis said.

At the other end of the spectrum, Taiwan, Korea, Hungary and China are among the most resilient.

In terms of consumption rates to GDP, the highest are found in the Philippines, Brazil, South Africa and Turkey and the lowest in China, Singapore, Malaysia and Indonesia.

Poland, the Czech Republic, Hungary and Turkey look vulnerable because of their high stock of net external liabilities, while Singapore, Taiwan and Israel are among the most resilient from that perspective.

The Philippines, China, Thailand, Korea, Turkey and Brazil look most vulnerable from a currency overvaluation perspective, while Taiwan, Poland, the Czech Republic, Hungary and South Africa "do not exhibit a clear currency valuation issue," Fiotakis said.

Other analysts, however, believe that the sell-off in emerging markets is near the end.

The outlook for the world economy is "fairly positive," some emerging market currencies look "fundamentally attractive" from a valuation point of view and, because the sell-off has pushed emerging market rates and yields up significantly, the carry is now significantly higher than before, according to Arne Lohmann Rasmussen, head of rates, FX and commodities strategy at Danske bank.

"We are therefore optimistic that the worst is behind us on the EM currencies and it is time to begin to look for opportunities in the EM FX universe," Rasmussen said. 

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