EM currencies: borrowing and sorrowing

The past year has seen several stresses imposed on the global economy. The Russian invasion of Ukraine, a renewed bout of strength in the dollar, and increasing anxiety in UK gilt markets, to name but a few.

In the face of this stress, the reaction among emerging market (EM) currencies, typically seen as a risky bet, has been varied. The Brazilian real has been one of the best performers against the strong dollar year to date, while the Polish zloty and Hungarian forint have been among the worst performers globally. How can we explain this divergence?

To answer this question, we use our newly developed Exchange Market Pressure (EMP) index, which includes both changes in the effective exchange rates and central bank interventions.

Just how mixed is EMs’ mixed bag?

The reaction in the EMP index highlights the varied response to the market turbulence seen since August 2021. Though central banks have stepped in to support currencies where they can, their interventions do not change a varied picture. Countries with strong upward pressure include Peru, Israel and Russia, whereas Chile, Hungary and Turkey have seen strong pressure to the downside.

Drivers of exchange market pressure

Another clue as to why this has happened may be the gyration in commodity prices (and consequent terms of trade changes). Recent increases in prices for food, energy and some key raw materials would place commodity-heavy EMs at an advantage, reflected in an improvement in their terms of trade.

However, using our EMP index, we see no relationship between terms of trade changes and accompanying pressure on the currency.

Rather than the terms of trade, we see exchange market stress being tied to external vulnerabilities, such as external debt and the current account. As global conditions have become less accommodative, investors have been more discerning within EMs, rather than withdrawing from EMs as a whole.

We believe investors are sticking with currencies less plagued by these external vulnerabilities.

EM migration: many flights to safety

As global recession becomes increasingly likely and financial conditions worsen, we believe this EM-only flight to safety has further to play out.

We now look more closely at metrics of external vulnerability, such as the current account, international investment position and external debt levels, to find potentially attractive currency positions.

On this basis, we are more constructive on countries such as South Korea and Israel, compared with fundamentally weaker countries such as Chile and the Philippines.

The reversal of this flight to safety, once global conditions improve again, will become a buying opportunity in these markets, we believe.