Investors wake up to emerging market currency risk

The panicked market reaction to the selloff in Chinese equities suggests much of the developed world has only just woken up to the risk that a slowing Chinese economy poses around the globe.

But it is nothing new for EM countries.

“The biggest surprise [about last week’s market panic] was not that China has slowed but that it’s come as such a surprise,” says Paul McNamara, EM portfolio manager at GAM Holding.

China’s slowdown has been worrying EM countries throughout 2015. It has been a year of falling commodity prices, brought lower, thanks in part, to drip-drip evidence that the Chinese investment drive — which fuelled growth in commodity countries and investor interest in their economies — was being checked.

Black Monday, says McNamara, was “a pretty intense dose of what we’ve been seeing all year”. It has been a year of consistent weakness, “a lot of which has been sourced in China”.

Take Colombia, a big oil producer. Its peso currency had fallen 24 per cent from the beginning of the year up until Black Monday, when it fell a further 4 per cent.

EM countries have been pummelled by double blows to the solar plexus all through the year. Punch one: the Chinese slowdown. Punch two: the continuous market focus on when teh U.S will raise rates, which has driven dollar strength and so weakened EM currencies.

The result is a fall of one-fifth over the past 12 months in JPMorgan’s EM currency index.

How much further can they fall? If fair valuation was an investor’s only benchmark, then for several EM currencies, the answer is: not much further.

“EM currencies are now going from being overvalued to being close to fair value or dipping into undervalued territory,” says EMEA strategist Arko Sen of Bank of America Merrill Lynch.

It follows five years of easy money — the quantitative easing programmes of the US, Japan and now the eurozone — which distorted resource allocations in emerging markets, says Daniel Tenengauzer, head of EM FX strategy at RBC Capital Markets.

“A rising dollar is part of a valuation adjustment that’s necessary in EM. Malaysia was very overvalued a year ago, it made a very significant adjustment and is now close to fair value. Mexico was about 5-10 per cent over. Now it’s under. “The vast majority [of EM currencies] are either close to fair value or are undervalued.”

But fair valuation is not the investor’s only benchmark. As Sen adds: “There’s not enough conviction to play [in EM currencies] even if they are undervalued. Valuations are quite interesting, but because of poor global risk sentiment, investors don’t want to take the risk.”

Instead, they are doing the opposite. Stuart Oakley, Nomura’s head of EM FX, recognises that foreign capital has been “closing out and running away from EM and back home” in fear of slowing and deleveraging EM economies and policy shifts.

Source : BusinessDay

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