INTERNATIONAL: Emerging-market currencies set to gain

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1 1 of 5 11/6/2012 8:07 PM Back to previous page document 1 of 1 INTERNATIONAL: Emerging-market currencies set to gain INTERNATIONAL: Emerging-market currencies set to gain2012,, Oxford Analytica Ltd, Oxford, United Kingdom, Oxford. Find a copy /fmt:kev:mtx:journal&genre=unknown&sid=proq:proq%3aoxresearch& atitle=international%3a+emerging-market+currencies+set+to+gain& title=oxresearch+daily+brief+service&issn=&date= &volume=&issue=&spage=1& au=&isbn=&jtitle=oxresearch+daily+brief+service&btitle= Abstract (summary) The outlook for emerging-market currencies. Real returns on risk-free assets are zero or negative, and equity market volatility is an ever-present danger. This makes currency returns an unusually large contributor to overall returns in an internationally invested portfolio. Full text SUBJECT:The outlook for emerging-market currencies. SIGNIFICANCE:Real returns on risk-free assets are zero or negative, and equity market volatility is an ever-present danger. This makes currency returns an unusually large contributor to overall returns in an internationally invested portfolio. ANALYSIS: Impacts. Emerging markets will outperform developed economies for the foreseeable future. More predictable policies have made emerging-market currencies attractive to investors. 'Currency wars' are unlikely to regain traction for as long as the global economy remains sluggish. Exposure to emerging-market (EM) currencies was until recently something most investors would prefer to avoid. Currency regimes and monetary policies in developing economies have for much of

2 2 of 5 11/6/2012 8:07 PM the post-1973 period proved unreliable and unstable. While private capital flows to emerging markets grew, outright currency exposure was avoided in several ways: Pegged currencies. Emerging-market monetary authorities often sought to run pegged exchange rates, partly to allay investors' fears of currency exposure. 'Dollarisation'. Investment in EMs was typically denominated in a stable international currency -- usually the US dollar. Currency hedging. Investors sold foreign currency in the forward market to ensure the exchange rate at which their local-investment returns are translated into their own currencies. Paradigm shift. Two developments have made direct exposure to EM currencies a favoured investment strategy: EM growth. Emerging markets have posted high and stable growth rates in the past two decades, and have performed particularly well compared to the developed markets during the recent financial turmoil. EMs as a group are expected to grow by more than 5.0% in the fourth quarter, compared to 1.5% for the developed economies (see PROSPECTS 2012 Q4: Global economy - September 3, 2012). New policies. In the 1990s, a combination of unreliable currency pegs and widespread dollarisation generated a new species of EM crisis -- the 'balance sheet crisis'. EMs have since embraced exchange-rate flexibility. As of April 2012, the IMF counted 66 floating exchange-rate regimes among its members. Among the G20 leading world economies, only Saudi Arabia is counted as running a pegged currency. Brazil, India, Indonesia, Mexico, South Africa, South Korea and Turkey are all categorised as running a version of 'floating' currency regime; Argentina, China and Russia are all counted as running un-pegged, albeit not quite 'floating', currencies. Back to the future?. In this context, the purchasing-power parity (PPP) model of exchange-rate determination may become increasingly relevant. The most useful version of PPP-- 'relative PPP' -- states that a bilateral exchange rate should move in the direction that would bring a basket of locally-priced goods into greater alignment with that of the foreign economy. The intuition is straightforward. When a Norwegian visitor to China observes that local prices are remarkably affordable, this visitor can infer that the Norwegian-Chinese bilateral exchange rate should move in favour of the Chinese unit. Presuming PPP.

3 3 of 5 11/6/2012 8:07 PM PPP has been difficult to substantiate partly because so few EM currencies have been flexible; pegged regimes have typically yielded long spells of invariant exchange-rate data, followed by 'structural breaks' when regimes collapse. Moreover, 'home bias' in developed-market investment portfolios meant that EM assets were treated as completely un-substitutable for developed ones, further inhibiting the expression of PPP. Today, with EM currencies treated as outright targets of investment strategy, and with the demise of pegged regimes, PPP may in fact yield insights into EM currency changes. Guideposts. Judging from PPP estimates alone, almost all G20 EM currencies are undervalued. Whether they represent good bets as currency targets might depend on the interaction of two guideposts: Inflation. An undervalued economy can achieve PPP-equivalency through inflation as well as currency appreciation. High-inflation economies might present less appealing targets for strategies that emphasise currency-adjusted returns. Mean-reversion. PPP is a medium- to long-term concept. A year in which a PPP-undervalued currency suffers an annual decline might well be followed by a strong performance the following year. Rouble. Looking back at 2011 average exchange rates, inflation rates and estimates of PPP, the best bets for 2012 might have been Mexico, Indonesia, South Africa and Russia: Russia appeared particularly attractive since its inflation rate was predicted to fall significantly between 2011 and 2012 (see RUSSIA: Economy is more resilient than in July 23, 2012). If 'mean reversion' was at work, good bets in 2012 would have been India, Argentina and Turkey, which all performed poorly in India in particular looked attractive if disinflation took hold in 2012 (see INDIA: Politics may blunt new reform offensive - September 17, 2012). All of the G20 EM currencies have declined in the first nine months of 2012 on average, compared to the average value in (The exception is China, whose currency is not a directly investible asset for foreign investors.) The furthest faller was predicted by PPP -- Brazil's currency has dropped 14% this year, and was unique among EM units as being overvalued in PPP terms ( see BRAZIL: Weaker real aims to aid lagging manufacturing - March 21, 2012). If 2012 remains a dismal year for G20 EM currencies, this could present a buying opportunity to position for a strong Risk.

4 4 of 5 11/6/2012 8:07 PM One of the major warning signs for investing in EM currency is the movement of relative prices. In general, the real exchange rate should appreciate when the economy undergoes advances in productivity, driving wage increases which must be shared across the traded and non-traded sectors of the economy (since labour is generally mobile between the two). Japan after the Second World War is the quintessential example of such appreciation. The yen has appreciated from 360 yen per dollar under the Bretton Woods system ( ) to well under 100 per dollar today. Nevertheless, there are situations in which relative prices shift due to transitory factors -- not least of which is over-exuberance of foreign investors, and commodity prices for exporters. Strong capital inflows in recent decades have frequently pushed up the value of non-traded activities in the recipient economies. This price signal attracts further resources, and hence an upward price dynamic. At the end of the cycle is an economy whose real exchange rate has been driven unsustainably high, leaving the quoted exchange rate vulnerable to a sharp downward correction. CONCLUSION: Emerging-market currencies might provide unusually large portfolio returns in 2013, following a so-far dismal The US central bank's decision to adopt a discretionary balance-sheet growth policy -- in its third round of quantitative easing (QE3), announced last week -- provides all the more reason to expect some vigour from emerging-market currencies against a softening dollar. Indexing (details) Subject Location International; Economic conditions; Foreign exchange rates; Financial institutions; Monetary policy; Public policy; Prices Brazil, India, Russia, United States, US, Argentina, China, Indonesia, Mexico, Norway

5 5 of 5 11/6/2012 8:07 PM Classification Identifier / keyword Title Publication title Pages 1110: Economic conditions & forecasts, 9180: International Brazil, India, Russia, United States, US, Argentina, China, Indonesia, Mexico, Norway, International, Economic conditions, Foreign exchange rates, Financial institutions, Monetary policy, Public policy, Prices INTERNATIONAL: Emerging-market currencies set to gain OxResearch Daily Brief Service n/a Publication year 2012 Publication date Sep 18, 2012 Year 2012 Publisher Place of publication Country of publication Journal subject Source type Language of publication Document type Oxford Analytica Ltd Oxford United Kingdom BUSINESS AND ECONOMICS Reports English News ProQuest document ID Document URL Copyright //search.proquest.com/docview / ?accountid=12702 Copyright Oxford Analytica Ltd No publication or distribution is permitted without the express consent of Oxford Analytica. Last updated Database OxResearch Bibliography Citation style: HARVARD INTERNATIONAL: Emerging-market currencies set to gain2012,, Oxford Analytica Ltd, Oxford, United Kingdom, Oxford. Copyright 2012 ProQuest LLC. All rights reserved. Terms and Conditions