What is going on with emerging market currencies?

By Kathleen Brooks, Research Director

Forex.com

Fast forward 12 months and emerging markets are complaining about their currencies again, but this time the problem is not strength but weakness. In the recent bout of market turmoil EM FX has been sold off indiscriminately. So how can you trade an asset class that is this capricious?

Investor sentiment crucial in risky assets trading

There are two main things you need to consider when trading emerging market FX. The first is the external market environment; are investors piling into risk or are they taking risk off the table? Since EM FX is grouped under risky assets, this means investor sentiment is absolutely crucial and should be the main consideration when deciding to make a trade.

Next you need to consider domestic conditions: is the country a big exporter and thus won't want its currency to appreciate too much? Is there a threat of central bank intervention? What are prices doing and where are interest rates expected to go?

Dealing with the latter point first, if you are interested in an emerging market get to know a bit about its economy first. For example, Brazil imposed capital controls in late 2010 to stop upward pressure on its currency after global investors were attracted to the high interest rates on offer and started to pile in. The central bank penalised any "foreign speculator" and charged them a tax for holding Brazilian real. That made it much more expensive and also more volatile and although the real appreciated more than 15% against the US dollar from June 2010 to June 2011, there were some harsh pull backs during that time.

Inflation fears spur emerging central banks' decisions

Likewise, the South African authorities also stepped in to limit currency appreciation after a storming rally in 2010. However, the latest bout of turmoil has heads of emerging central banks extremely worried, but for different reasons. This time it is inflation. If their currencies fall too quickly then it makes imports more expensive and puts upward pressure on prices. In the same way that high food and energy prices sparked the Arab Spring protests earlier this year, countries as diverse as Turkey and Hungary are concerned about keeping prices stable to prevent social discord. Due to this they have either; 1, embarked on intervention to buy their currency in an attempt to try and stop it from falling any further; or 2, suggested that interest rates will have to rise.

The Turkish lira has lost a quarter of its value versus the dollar since May this year, which has helped to push inflation back to 2-year highs. This is particularly worrying for Turkey, firstly due to its proximity to the Middle East and the centre of recent protests and also because it may cause more unemployment. Already nearly 10% of the work force is unemployed according to the latest official figures, but if prices rise then this could constrain consumer spending and hurt businesses forcing them to cut staff.

Likewise, although Hungary has seen prices decline since the start of the year, they have begun to rise once more, which is something the central bank will want to avoid. For emerging markets to try and gain economic credibility their central bankers need to ensure that extreme movements in prices and hyper inflation are consigned to history, thus, we think that central bankers across the emerging world will continue to do what it takes to ensure inflation levels are controlled, even if this weighs on growth.

The second thing to consider is the prevailing market trend. Broadly speaking, free-floating emerging market currencies followed the euro sharply lower during the recent bout of economic turmoil. This is because all asset classes (including gold) were sold off as investors flocked to the safety of the dollar. But how can the dollar be perceived as safe when it has $14 trillion of debt and was recently stripped of its triple A credit rating? This is a good question, however the dollar is the most liquid currency in the world and when there is a risk of a sovereign debt crisis in Europe and the potential collapse of the single currency investors want to be in the most widely-traded currency they can - which is still the dollar. So in recent weeks emerging market currencies have been sacrificed for a more liquid alternative.

So for all of those still interested in the more exotic end of the currency market, expect volatility. Some of emerging currencies will be caught in a tug-of-war between negative market sentiment on one side - that will put downward pressure on EM FX - and central bankers desperate to provide price stability and thus offering support on the other. One thing is for sure, these currencies are not for the faint-hearted.