Don’t go with the flow

WHEN Brazil’s finance minister Guido Mantega last week warned of an international currency war, he said what many other emerging market policymakers were privately thinking. Competitive devaluations have become a hot topic of discussion and there are growing calls for an international accord to help coordinate a rebalancing of the global economy.

According to the Institute of International Finance (IIF), the low interest rate environment in the mature economies is driving money into emerging markets in search of higher yields and strong economic growth. “The persistent strength in private capital inflows raises new headaches for emerging market policy makers. For one thing, flows are apt to lead to upward pressure on emerging market real exchange rates vis-à-vis most mature market currencies,” the IIF says.

According to Societe Generale’s Kit Juckes, central banks face three choices: let the currency appreciate, impose some form of capital control, or import US monetary policies and accept domestic asset inflation. Some in the developing world have opted for the second option in order to keep their currencies deliberately weak and competitive compared to China with its still-inflexible yuan policy.

John Hardy, FX consultant at Saxo Bank, says: “As long as countries are seen as unable to effectively intervene – Brazil, Korea and Mexico are already taking measures – and outright safe haven-seeking fails to develop, the flows are going where the yields are. Those point to the emerging markets with their higher yields as well as Australia, which has both the yield and the leveraged exposure to emerging market strength via its export industries.”

The IIF adds that recent renewed upward pressure on emerging market FX rates needs to be seen in context. Many of these weakened in the second quarter so the recent appreciation is merely a natural rebound. Moreover, on a purchasing power parity basis, many emerging market currencies are undervalued.

While the signs are clearly pointing towards long-term appreciation in emerging market FX, it is likely to be a white-knuckle ride for traders in these currencies over the next couple of months as the developed world loosens monetary policy further and the emerging markets try to impose further capital controls.

Those who want to avoid this volatility should look towards Norway, Canada and Australia. All three benefit from greater fiscal prudence, a move towards monetary policy normalisation and exposure to commodity demand. These will provide steady returns without being directly affected by policy intervention.