By Natalia Gurushina
Chief Economist, Emerging Markets Fixed Income
EM FX Devaluations
An FT article caught our attention this morning – but it’s not the one about the sustainability of Japan’s central bank government bond purchases and potential changes in the yield curve control mechanism (YCC) under the new governor (albeit this might have very serious implications for global Fixed Income, especially Investment Grade instruments with their super-tight spreads). “Our” article talks about “a spate” and “a further slew” of emerging markets (EM) FX devaluations caused by the strong U.S. Dollar. We are not sure how well this characterizes EM, especially in light of strong performance of many EM currencies last year or a dramatic repricing lower of Asian interest rates. Further, letting currencies go while accelerating structural reforms and engaging multilateral financial support is probably the best thing that can happen to developing economies from the longer-term perspective. This is the lesson learned by their predecessors – many of whom are now “EM Graduates” – in the wake of the 1997/98 global financial crisis. Egypt is not doing this – yet – and therefore still strikes us as vulnerable to such episodes – it’s really a “classic” setup including the part about learning the hard way.
EM Structural Adjustment
Using FX as a shock-absorber – while relying on interest rates as the primary policy instrument to target inflation – helps to initiate a “textbook” adjustment of the current account balance (less imports and more competitive exports). With fewer FX interventions, this is the fastest way to start rebuilding the international reserves. Over time, the accumulation of reserves and a stronger structural/institutional backdrop should lead to a major decline in sovereign spreads, limiting the extent of potential “flare-ups” in the future. The chart below demonstrates all these points very well (higher reserves/tighter spreads/lower peaks). Many EMs are now net sovereign creditors in U.S. dollars!
EM FX And U.S. Dollar
EMs that used their past devaluation experiences wisely – reforms, accumulation of reserves, inflation-targeting – are now less tied up to the U.S. Dollar cycle. The Brazilian real, the Mexican peso, the Peruvian sol, and the Chilean peso ended up stronger vs. the U.S. Dollar last year. The final point here is that there are different ways to get exposure to emerging markets these days. For example, we don’t like Brazil’s local market currently (due to policy noise), so we just don’t own it…but the current environment can still be positive for Brazilian credits that pay in real and earn in U.S. Dollar (for example). Stay tuned!
Chart at a Glance: EM Reserves vs. Sovereign Spreads in Different Regimes
Source: Bloomberg LP.
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PMI – Purchasing Managers’ Index: economic indicators derived from monthly surveys of private sector companies. A reading above 50 indicates expansion, and a reading below 50 indicates contraction; ISM – Institute for Supply Management PMI: ISM releases an index based on more than 400 purchasing and supply managers surveys; both in the manufacturing and non-manufacturing industries; CPI – Consumer Price Index: an index of the variation in prices paid by typical consumers for retail goods and other items; PPI – Producer Price Index: a family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time; PCE inflation – Personal Consumption Expenditures Price Index: one measure of U.S. inflation, tracking the change in prices of goods and services purchased by consumers throughout the economy; MSCI – Morgan Stanley Capital International: an American provider of equity, fixed income, hedge fund stock market indexes, and equity portfolio analysis tools; VIX – CBOE Volatility Index: an index created by the Chicago Board Options Exchange (CBOE), which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities on S&P 500 index options.; GBI-EM – JP Morgan’s Government Bond Index – Emerging Markets: comprehensive emerging market debt benchmarks that track local currency bonds issued by Emerging market governments; EMBI – JP Morgan’s Emerging Market Bond Index: JP Morgan’s index of dollar-denominated sovereign bonds issued by a selection of emerging market countries; EMBIG – JP Morgan’s Emerging Market Bond Index Global: tracks total returns for traded external debt instruments in emerging markets.
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