Why are emerging market currencies going into a free fall?

The 2% devaluation of the Yuan was the beginning of something that could become a contagion shortly. In fact, it has already started! Immediately after the Chinese devalued the Yuan, the Vietnamese Dong and the Kazakh Tenge sharply lost value. Many other currencies like the Korean Won, Brazilian Real and Turkish Lira have also been losing value. But why this free fall?

Many emerging markets are commodity driven…

That is a fact. Most Latin American nations depend on oil and metal exports. Africa is largely an exporter of precious metals, industrial metals and oil. Asian economies like Indonesia and Malaysia are overtly focused on metals and other agricultural commodities. Central Asian nations have a different problem. Firstly, they are either major exporters of oil or gas, apart from gold. A sharp fall in prices and demand for these commodities has kept their currencies weak. Secondly, most central Asian economies have predominant trade links with Russia and the weak rouble has also forced the devaluation. Therefore, weak prices of oil and other metals is the first key reason for weak emerging market currencies.

They need to export their way out of trouble…

Most of the commodity driven economies depend on China as the largest consumer of commodities. Falling Chinese demand and a weak Yuan makes a basket case for these emerging markets to weaken their currencies. After all, a weak local currency will give them the relative advantage when exporting to China. Countries like India are also affected due to the large trade deficits that they run with China. A cheap Yuan will result in dumping of Chinese products into India. Chinese steel and tires are already 25-30% cheaper. A weak Yuan automatically forces a devaluation of the rupee to stay competitive.

Unwinding of the Euro carry trades…

The big trade in the last few years was the Euro carry trade. It entails borrowing in Euros and investing the proceeds in emerging markets. For the last few years it worked perfectly well. The Euro was weakening and emerging markets held on. This made the task quite simple. Things have changed in the recent past. A weakening of the Yuan has led to a strengthening of the Euro as it is China’s largest trading partner. This has created a case for unwinding of carry trades as the Euro gets stronger and the emerging market currencies become weaker. In a way, weak currency seems to be feeding on itself.

Free float preferred to price bands…

In case of the Vietnamese dong and the Kazakh tenge, the price band for the currency was abandoned in favour of a free float. A price band calls for sufficient foreign exchange reserves with the central bank to defend the band. Most emerging markets either do not have that kind of exchange reserves or do not see the economic logic in continuing to defend the price band even at the cost of depleting their foreign exchange reserves. This preference for a free float as an expedient option seems to be largely responsible for the free fall in emerging market currencies.

Currencies are adjusting for the wealth effect…

That is probably the most important point. Cheap money policies over the last 7 years had created a flush of liquidity in global markets. Emerging markets have been the largest beneficiary of this liquidity largesse and that has inflated asset prices across emerging markets. One needs to remember that when there is a relentless flow of liquidity then the easy money tends to debase the value of the currency. The devaluation that we are seeing in emerging markets is essentially an adjustment for inflated asset values across emerging markets.

To sum it up, the emerging market free fall in currencies may be here to stay. As nations try to export their way out of trouble, devaluation may be the easiest choice. Seven years of asset price inflation called for a drastic adjustment. The devaluation of currencies may be the market’s method of doing things.

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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