dari morgan stanley global forum
Currencies
EM Currencies: Sell Into the Rally
November 03, 2008
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions
We believe that we are closer to the beginning than to the end of the global
currency 'moment'. The global equity market rally in the past few days may
continue in the near term. But this, in our view, will offer investors a great
opportunity to hedge against the risk of further EM currency weakness. We do
not share the popular view that the IMF's newest facility - Short-Term
Liquidity Facility (SLF) - is a 'game-changer'. Rather, we believe that it
will only have marginally positive effects on EM currencies not powerful enough
to offset the strong headwinds to buffet EM currencies in the coming two
quarters or so. There are also lessons from the Asian Crisis that are relevant
in the EM discussion.
Our Thesis on EM Currencies
We have been bearish on Asian currencies since May 1, 2008, and warned in July
about an impending sell-off in Latin American currencies (BRL and MXN), to be
followed by sell-offs in TRY and ZAR, along with the Eastern European (EE)
currencies. This script has played out reasonably well.
Our thesis on EM rests on three legs. First, EM corporates and other local
entities were drawn into short-USD structured positions, due to an extended
period of low volatility, USD weakness and a positive carry against the USD.
In fact, much of the sell-off in EM currencies we've witnessed is, in our
opinion, due to local corporates and other players unwinding these USD shorts.
Second, the world's capital flows (portfolio, FDI and loan flows) will likely
fall sharply in 2009, as the global economy slows. This is a risk that is
still ahead of us, not behind us.
Third, this sell-off in EM currencies seems likely to prompt investors to
reexamine the longer-term EM story - i.e., that EM economies will consistently
generate superior growth. In fact, some of that story, in our view, was a
derivative of booming global growth, in turn partly fueled by easy credit in
the developed world. While several EM economies did enact significant and
sustainable structural reforms that have contributed to their recent
outperformance, in our view, at least part of the story is traceable to global
rather than country-specific factors.
This Thesis of Ours Is Being Challenged
The rally in global equities in recent days has made some investors doubtful of
our thesis on EM. In contrast, we see this rally in risky assets as a good
opportunity for investors to curtail their exposure to EM. In other words, as
long as the global economy is decelerating, and especially the 'second
derivative' of global output is negative, investors should sell EM currencies
on rallies, not buy them on dips.
We Are Unconvinced That the IMF's SLF Is a 'Game-Changer'
The IMF's newest facility and the Fed's swap lines announced last night have
also added to the positive sentiment towards EM. We are unconvinced that the
SLF is a game-changer.
Having more dollars can't hurt in this environment. But the irony here is that
many of the 'good' countries (Brazil, Korea, Mexico and India) already have a
lot of reserves (the three countries have a total of more than US$800 billion
in official reserves). We need to ask why these reserves have not prevented
their currencies from weakening, and why people think that another US$60-100
billion from the IMF will do the trick. Our answer to this question is that
the global economic fundamentals are deteriorating rapidly. Global
fundamentals will drive EM currencies, not country fundamentals. This is why
we believe that the IMF's SLF will help but ultimately will have a marginal
effect, and will certainly not stop the depreciating trends in EM currencies.
While we think that this facility is sensible, we doubt that it will fully
offset the gale-force global headwind impinging on the EM economies. We may
need to tweak slightly some of the FX forecasts, but we believe that EM
currencies are heading lower as the world falls into a deep recession,
regardless of whether the country in question is good, bad or ugly. Here are
some specific thoughts we have on the SLF.
1. The IMF's SLF versus the Fed's swap lines. The two are clearly
different facilities. The IMF's SLF is essentially a three-year boost to the
borrowing countries' official reserves, to be repaid of course. On the other
hand, the Fed's swap lines are just that: they make no net difference to the
overall abundance of official reserves, but will help if a country has
'liquidity issues' with underlying assets such as Agencies on which they might
not want to take losses. The swap lines essentially permit EM central banks to
hold their underlying assets to maturity, which is important to some central
banks with large holdings of Agencies and MBS. Of course, there might be
reasons to think it is also in the US interest to avoid 'fire sales' of US
Agencies or MBS by foreign central banks.
2. These facilities should help to limit the undershoot in the EM
currencies. Having more dollars is clearly a good thing.
3. But many of these countries already have a lot of foreign reserves.
Let's take Russia as an example. It started out with US$600 billion in
reserves, which have been run down to possibly US$485 billion or so now.
That's still a lot of money. We need to ask why US$600 billion was barely
enough to cap the pressures on RUB, and why US$485 billion will not be enough
to avert a RUB depreciation. Not too long ago, India had US$400 billion in
reserves. Yet USD/INR has risen from 40.0 to 50.0. We need to ask not just
why this has happened, but also why this was allowed to happen when the RBI had
so much in reserves? Further, Korea had, according to the latest data
available, US$240 billion in reserves. Why did Korea permit USD/KRW to rise
from a little more than 1,000 to 1,400, when it had so much in reserves?
One possibility is that a meaningful portion of their reserve holdings are not
in very liquid assets or assets they would take a loss on if sold. Another
possibility is that the policymakers either prefer to allow some currency
depreciation to help shield them from the shock of a global recession, or may,
for some reason, suspect that they may not be able to defend a hard line in the
sand. In both cases, it is hard to see how another US$20 or so billion for
each of these reserve-rich economies would be game-changers.
4. But EM currencies will still weaken substantially from here, due to
fundamental reasons: global fundamentals, not country fundamentals. Global
capital flows to EM could decline from US$750 billion a year to US$300 billion
next year, in our view. All else equal, EM would need to 'spend' US$450
billion in 2009 just to keep their currencies from weakening. But if global
growth slows, the economic fundamentals of EM will deteriorate, which will
naturally drive their currencies weaker, or persuade the policymakers to allow
their currencies to depreciate.
IMF a Game-Changer? A Historical Perspective
While interventions by the IMF are major deals during EM crises, the
announcements of IMF programmes more often than not have had little impact on
the currencies in question. Let's recap what happened during the Asian Crisis.
The IMF announced Stand-By Arrangements (SBAs) with Thailand in August 1997,
Indonesia in November 1997, Korea in December 1997 and the Philippines in April
1998. With the sole exception of Korea, the currencies continued to depreciate
sharply, for an extended period, after the IMF initiated SBAs. Over the
ensuing years, IDR, PHP and THB never really recovered much of the valuation
losses, even with the IMF programme.
The KRW was able to rally hard mainly because of the sharp turnaround in its
C/A balance - a swing of more than US$30 billion from 1997 to 1999. However,
during that period, the global economy was reasonably robust, allowing
export-oriented economies to capitalise on their cheaper currencies. This time
around, the entire global economy is likely to remain very weak, making the KRW
experience difficult to be repeated, in our view.
In short, IMF programs may be game-changers for the economies in question, but
they were very ineffective in altering the trajectories of the exchange rates.
Bottom Line
We remain very worried about EM currencies, and believe that investors should
sell into short-term rallies in the underlying assets and EM currencies so as
to hedge against further EM currency weakness. The IMF's latest facility and
the Fed's swap lines will provide marginal support for selected EM currencies,
but will not be big enough to fully offset the powerful forces of a global
recession pushing EM currencies lower from here.
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