The Currency Conundrum
Rampant inflation has set the cat among the pigeons for currency managers seeking rewards in emerging markets. The problem is partly that central banks in Asia have failed to tighten monetary policy as expected, preferring fuel subsidies and restrictions on food exports to a modest period of austerity.
Elsewhere, those traders who attacked the Middle East dollar pegs throughout the Spring have failed to break them. But that hasn’t deterred them from trying again. “Just recently we’ve seen an enormous surge in investor appetite for GCC trades especially around the Saudi currency,” says Peter Rosenstreich, chief market analyst at Advanced Currency Markets, an FX broker. The excitement followed a comment by a senior Saudi council member that a 20 percent revaluation of the riyal is necessary.
“This has always been a story that people are watching and many still have this sort of revaluation priced into their macro trade,” Rosenstreich explains. “So every time you have a statement like this, the market regains that appetite. But we believe traders need to temper their reaction right now.” He says the underlying fundamental reasons why policymakers would revalue remain intact, but they are concerned about another bout of dollar weakness and the fact that a destabilising revaluation could complicate the progress towards monetary union in the Middle East. This is despite the fact that inflation in Saudi Arabia is over 10 percent.
An unsuitable peg
In July, Goldman Sachs published a report examining whether the Gulf currencies are more suited to a dollar peg or a euro peg, and found in favour of the latter. In particular, Qatar, Saudi and the UAE all had very low scores for dollar peg suitability. The report argued that the dollar peg is unsuitable for Middle Eastern economies because they also have strong trading links with the Eurozone – so when the dollar weakens, their own currencies depreciate noticeably versus most currencies – especially the euro. This has increased import prices.
Mark Farrington, head of currency at Principal Global Investors (Europe), believes the dollar has now bottomed, “but it won’t rise for a while, so it takes the pressure off the pegged currencies to deal with a moving target”. He says it is fine for small economies to have a dollar peg, as long as they understand that the impact of an adverse movement must be taken through the domestic economy, rather than through the currency.
“In Hong Kong everyone now understands that if Asia has a recession, asset prices collapse in Hong Kong because they have to take the slowdown effects through wages and asset prices domestically rather than through the currency and interest rates,” he explains. “I don’t think the Middle East is familiar with that picture, although in the Gulf the business cycle can be smoothed for the general population via subsidies.”
But over time he expects this to change: “In Dubai there is now a lot of non-Arab money and they are exposed to the same economic forces. So I don’t know how they’re going to cope with a major recession in the Middle East. I think it will be a big boom and bust story.”
This happened in Hong Kong’s property market in the early years of the peg, which wiped out a lot of speculative money. “Then it made a stand and defended its peg and now it is accepted as part of the furniture there. So the Middle East still has a lot of pain to go through before they are as stable as the Hong Kong peg.”
Political pressure
Currency managers like Investec are not optimistic that the Gulf pegs will be abandoned any time soon. “At the moment the political pressure to retain the dollar peg is too high, so it is unlikely that they will move in the next six months,” says Werner Gey van Pittius, emerging markets currency manager at Investec Asset Management. “But we might see the central banks start buying euros. That’s what Russia did when it came off the dollar peg.” He adds that countries like Ukraine, where consumer price inflation is running at over 23 percent, is buying euros with the aim of moving to a euro/dollar basket. When their reserves are 50/50 euro/dollar, they will peg to this basket.
Investec has stayed away from the Gulf currencies because of this uncertainty over the dollar peg: “It uses up your capital and we prefer to play Egypt as a proxy, which runs a managed float,” Gey van Pittius explains. He sees more willingness in Egypt to allow the currency to appreciate and some Middle Eastern countries are re-investing their oil revenues there. “It also has the Suez canal and tourism revenues, so it is a much safer bet, as the likelihood of appreciation is much higher.”
Whilst high yielding emerging market currencies are still paying off for currency managers on the back of strong inflows to emerging market bonds, some analysts are growing uneasy. Jim McCormick, global head of FX strategy at Lehman Brothers, believes that many emerging market currencies are close to their highs, and is far from impressed with how central banks are handling the rise in inflation. “We are also seeing systemic risk increase. Currency weakness is already being seen in Iceland, Vietnam and Romania.” Poland, Hungary and Turkey have also exhibited recent spikes in risk.
PGI’s Farrington points out that the most vulnerable currencies are those where the country is relatively close to a current account deficit and dependent on high commodity prices to keep it above water, especially if it has a large amount of foreign currency debt. If commodities come off, these countries could be looking at an old-school balance of payments crisis.
Currency contagion
One saving grace is that emerging market contagion will probably play out in a more benign manner than in previous crises. He suggests that countries like Venezuela, Argentina, the Philippines, Vietnam and Zimbabwe will break first. “Then you will have the contagion trade, where everyone trades those currencies that look a little bit vulnerable. Next it will hit the stronger emerging market currencies, but they will be able to withstand the attack. So contagion will roll out but it won’t roll very far.”
Instead of chasing the high yielding emerging market deficit currencies, Farrington recommends shorting the Anglo-Saxon business model currencies, such as the Australian and New Zealand dollars and the UK pound, against the US dollar, as their banking sectors will be more affected by the credit crunch. “This should help bring inflation down as GDP will run well below trend for at least a year, it will create an output gap, and this will allow rates to be cut.” In other countries, however, inflation is unlikely to come down far enough to allow their central banks to cut rates.
He adds that currently, the currencies that get punished the most are those where the central bank is given the freedom to cut interest rates. He points out that the South African rand is rallying, regardless of the negative underlying fundamentals, because the central bank is tightening. “Whereas Australia has fantastic fundamentals and the minute the bank starts to cut rates they will sell that currency. It’s a lingering perverse logic driven by the carry trade.”
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