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Marcuard's Market update by GaveKal Research
Ever since the Asian crisis of 1997, emerging market countries have built up foreign currency reserves as ammunition against speculative currency attacks. Now we can only hope they do not try to use them.
Drawing lines in the sand on currency levels, or trying to protect an exchange rate with heavy foreign-exchange interventions, only provides a target for speculators to aim at, resulting in a costly FX reserve drain. Call it the Soros effect. After George Soros’ GBP 1bln pay-off betting against sterling in 1992, investors have tended to test central banks’ attempts to defend the value of a currency. Trying to use FX reserve firepower to prop up a flagging exchange rate is asking for trouble.
In the emerging market currency sell-off that began in May, we have not seen any official lines drawn in the sand. We have, however, heard veiled threats and seen flirting with unofficial or “whispered” targets. Indonesia and India are among the countries that have intervened regularly in their currencies, while Brazil last week announced it is injecting US$60bn in liquidity into the foreign exchange market.
There are rare cases when intervention to support a currency can conquer the market—Hong Kong left short-sell investors hurting after its 1998 intervention in stocks and the currency market. But most emerging markets don’t have this luxury. A number of academic studies have shown that once speculators gain a critical mass, it is better for policymakers not to intervene.
In the face of potentially imminent Federal Reserve tapering, large reserves have not been a sufficient deterrent to prevent sharp currency devaluations. Since May, Turkish lira and Indonesian rupiah are down –12%, the Indian rupee has dropped nearly –21% and the Brazilian real has fallen –19%. All these countries have seen large build-ups in their reserves in the past decade or so—but they also have the common problem of depending on continuous foreign capital flows to finance current account deficits.
Indeed, as Joyce outlined in a piece published last Friday, investors are focusing on economic fundamentals, as reflected in the current account balance or the percentage of outstanding bonds held by foreigners. We developed a risk monitor tool to measure such risk. The countries that were deemed most risky are the same ones whose currencies have been hit the hardest, falling to levels seen just after the Global Financial Crisis hit.
One interesting exception is Brazil. Its balance sheet fundamentals are not as vulnerable as the riskiest emerging market peers, yet its currency has been hit as hard. One wonders if this partly reflects the country’s attempts to micro-manage the exchange rate in the past couple of years—first to guide it lower, then to stop it from overshooting. The Brazil operation provides substantial US dollar liquidity which may ease stress on the real at least in the near term. However, policy credibility is something that has been lacking in Brasilia of late. Brazil might be safer if it lets the real find its own level.
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