Currency markets are making headlines again after taking a low profile amid the crises and the turmoil in financial markets of the last five years or so. I asked Greg Saichin, Head of High Yield and Emerging Markets Fixed Income Portfolio Management here at Pioneer, to provide his views about what is going on, and what he sees as the drivers of investment flows into emerging markets.
Are record flows to Emerging Markets (EM) putting upward pressure on their currencies?
Not necessarily. There are several kinds of investment flows going into EM and not all of them are as speculative as carry trades, which exploit wide gaps between borrowed and invested money. Interest rates have been falling since last year in most EM and the conversion to growth-oriented policies was timely enough to prevent a serious downturn.
As a result, foreign direct investment (FDI), which looks for good opportunities in the real economy, is still flowing and its support of currencies tends to offset the reduced support from interest rates. This is important, as a large contribution of FDI tends to make the mix of foreign flows less volatile by reducing the impact of fast-moving financial flows. We believe FDI should be a long-term support if, as we expect, economic policies are set to become more and more responsible, notably on the fiscal side.
Are currency wars a possibility?
Political leaders appear to be narrowly focused on their own economies.
- France’s president has so far been the most vocal opponent of a supposedly strong euro to sustain French companies’ exports.
- The U.S. dollar is already weak and, unlike France and other crisis-hit EU countries, could make up for little or no room for stimulus on the fiscal side.
- China has so far resisted a massive currency appreciation for fear that exporters risk losing market share.
- Japan is adding to the group of countries seeking a weak currency through overly loose policies, endorsed by a more accommodative central bank. It’s remarkable that complaints about unfair competition are pretty loud against Japan now, whereas the Fed could make its quantitative easing more and more aggressive without triggering the same accusations.
- The list of complainers may become even longer, first pitting Japan against China (the two East Asian powerhouses are also at odds for territorial issues) and then others in the same region, starting with South Korea.
In the end, we can expect other EM trying to join the global search for lower currencies, although Fed-style unconventional measures may be hard to adopt as inflation is still a material constraint in most cases.
What are the pros and cons of local currency markets today?
Today, local-currency markets tend to be more stable, as domestic players hold a large share and yields are often higher than hard-currency assets. The relative lack of liquidity is becoming less of a problem, as pension funds and other institutional investors are helping to make this segment increasingly resilient.
The most speculative aspect is tied to other instruments, such as short-term debt, which international investors mostly use for currency bets. Of course, foreign investors’ access to local markets may be subject to limitations or other nuisances. For example, Brazil’s attempts to weaken its currency prompted it to slap a tax on foreign purchases of assets. There is no such risk for assets denominated in U.S. dollars or euros.
Ultimately, when considering investment in developing markets, investors should look to the same variables as in developed markets. Start with public and private debt levels. Trends to watch can now be seen in Brazil and other Latin American countries where household debt has risen sharply. In China, bank debt needs to be monitored closely, not only for its size on GDP but also for its diversity, with a shadow banking system making regulators’ work maddeningly difficult. We believe that the ability to check credit growth is key for overall economic prospects in a country so reliant on the banking industry.
While there’s room for EM currencies to weaken a bit in the short run as monetary policies turn more expansionary and interest-rate support declines, we expect the growth potential of most EM countries to lead to stronger currencies over time.