EM FX Doing the rounds Nordea Research, 14 February 2014

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1 M FX Doing the rounds Nordea Research, 14 February 2014 Deanie Marie Haugaard Jensen Global Research Near-term relief amid a stream of positive news despite a devaluation in Kazakhstan Is it time to break the last EM pegs? So far, three phases of EM sell-offs we are not done yet! Potential near-term triggers: EM political risk Temporary relief After a storm comes a calm the storm being the January sell-off and the calm being now. A steady stream of positive news has translated into some much needed relief for pressured Emerging Market currencies. Especially, the Turkish lira has staged quite a comeback. It is, however, still windy in some EMs with deep domestic problems such as Kazakhstan where the authorities earlier this week decided to devalue the tenge in an attempt to restore external competitiveness, see KZT: Kazakhstan devalued tenge, history repeats itself. We see near-term risks of a renewed EM sell-off as elections in several EM countries could disrupt the current calm sentiment. First up is Turkey, where local elections are set for 30 March. With an already fragile political situation amid the corruption scandal from December 2013, we suspect that sentiment could once again turn against the Turkish lira, and potentially spread to other EM FX as well, such as the South African rand. Chart 1: The February calm after the January storm % change EM FX vs. USD 1 week change % change Stronger currency TRY PLN RUB HUF MXN RON CLP BRL PHP CZK ZAR IDR THB INR Contents Temporary relief... 1 Break of pegs?... 2 Sell-off phases... 3 No new normal just repeating past trends... 4 nordeamarkets.com/research

2 Break of pegs? The short answer is no. Devaluations and pegs are back on the table So far, the EM FX universe has seen one broken peg and one devaluation. The broken peg is the Argentine peso-peg, which was left on 23 January, while the devaluation was delivered on 11 February by the Kazakhstan central bank. Despite the relatively short time span between the two FX events, they are not closely interlinked as they differ widely in terms of trigger and risk of contagion. Chart 2: Two effective devaluations in the EM universe May 2013 = USD/BRL USD/TRY USD/IDR USD/THB USD/ZAR USD/ARS USD/KZT USD/UAH EM FX EM devaluations May 2013 = May Jun Jul Aug Sep Oct Nov Dec Jan Feb The tenge was pressured by Fed s tapering the peso by bad domestic policies Little risk of contagion from Argentina Regarding the trigger, the National Bank of Kazakhstan quoted rising pressure from the Fed tapering and the resulting weakening of the EM currencies including the Russian rouble as the main reason for devaluing. In contrast, the trigger was not external in the case of Argentina. Instead, it was the inevitable outcome of mismanaged macroeconomic policies. For several years the Argentine government has been monetizing a public deficit, fuelling one of the world s highest inflation rates; this combined with strict FX controls led to a parallel currency market where the peso trades at a discount of 60-70% to the official exchange rate. Therefore, letting the peso float was a desperate (or smart time will show) strategy to stop the bleeding of scarce FX reserves. In short, the trigger was (to some extent) external in the case of Kazakhstan, while internal for Argentina. This is also why we see little risk of contagion in the case of Argentina. That being said, the Argentine depreciation does pose a downside risk to Brazil s already sluggish growth in 2014 (we expect below 2%). Argentina is Brazil s third largest trading partner and negative spill-overs will likely go through the industrial sector as 76% of Brazil s exports to Argentina are high-cost manufactured goods, which require extended supply chains. 2

3 Chart 3: Brazil s trade with Argentina % y/y Trade and GDP growth Brazil's exports to Argentina Brazil's GDP growth % y/y KZT devaluation may spread to other EMs On the other hand, the Kazakhstan devaluation has the potential to spread to other EM currencies, as it is a competitive devaluation. Especially, the Ukraine hryvnia could come under even more pressure. Basically, if the relatively stronger central bank of Kazakhstan has come to the conclusion that a competitive devaluation was needed it should not be too long before the Ukraine central bank reaches the same conclusion. However, Ukraine first needs to appoint a new Prime Minister. See also Ukraine: Increased risks for devaluation and default. Sell-off phases Since last summer when the Fed first hinted at tapering the world has witnessed three distinct phases of EM sell-offs: Phase 1: Indiscrimination sell-off in June 2013 triggered by fear of the Fed s tapering of its asset purchases and a hard landing in China. Phase 2: Good versus bad sell-off in August 2013, where we saw some discrimination among EM countries running current account surpluses and deficits. Phase 3: Quick and dirty sell-off in January 2014 with continued discrimination between EM countries where more countries was added to the group of bad EMs. EM FX has gone a lot of the way Interestingly, the time span of each sell-off phase has shortened, indicating that the need for correction becomes smaller and smaller as many EM currencies are approaching more reasonable levels compared to before May

4 Chart 4: The 3 phases of EM sell-offs May EM assets vs DM assets during 3 phases of sell-offs DM follows EM S&P 500 index, rhs EM average vs USD, reversed scale May 2013= Jun Jul Aug Sep Oct Nov Dec Jan Still a need for adjustment in EM FX Divergence driven by China, commodities and interest rates Also, during all three sell-off phases there was a pronounced positive correlation between the S&P 500 and the EM FX indicator, suggesting that the sell-off does not just affect EM countries, but also the developed world. However, the trend still points to a negative correlation between the two asset classes, where EM FX has in general weakened, while the S&P 500 has continued to increase. No new normal just repeating past trends Zooming out on Chart 4, it should be fairly clear that a negative correlation between EM FX and the S&P 500 has previously prevailed for extended periods of time (see Chart 5). During the era of financial crises in the EM universe from 1994 to 2001 there was a clear and rather consistent negative correlation between EM FX and the S&P 500. This was followed by a prolonged period of positive correlation driven first by a strong positive sentiment ( ) and then a negative sentiment ( ), taking both asset classes in the same direction. Around 2011 something changed and divergence became a theme once again, indicating that EM countries are returning to an old normal not a new normal. The positive sentiment between 2002 and 2008 was largely driven by China s growth miracle, higher commodity prices and low interest rates. Since then growth in China has slowed, commodity prices have fallen and interest rates are more likely than not to rise. This type of environment is unlikely to be EM supportive and we will likely continue to see the need for an adjustment in the EM FX universe. After a storm comes a calm and after that calm, there will be another storm. 4

5 Chart 5: The bigger picture divergence, convergence, divergence EM assets vs DM assets May 2013 = Return to normal? EM crises S&P 500 index, rhs EM FX avg. vs USD, reversed scale Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S. The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the risks related to it, and it should not be relied on as such, nor is it a substitute for the judgement of the recipient. The information provided herein is not intended to constitute and does not constitute investment advice nor is the information intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has no regard to the specific investment objectives, the financial situation or particular needs of any particular recipient. Relevant and specific professional advice should always be obtained before making any investment or credit decision. It is important to note that past performance is not indicative of future results. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets. 5