Emerging-Market Rout Seen Enduring on Low Real Rates: Currencies

Feb 03, 2014 4:25 am ET

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Feb. 3 (Bloomberg) -- Inflation-adjusted interest rates are still too low in developing nations for Citigroup Inc. and Goldman Sachs Group Inc. to foresee an end to the worst emerging-market currency selloff in five years.

One-year borrowing costs in Turkey are 3.6 percent, less than half of the average in the three years before the 2008 global financial crisis, even after the central bank doubled its benchmark rate last week, according to data compiled by Bloomberg. The real rate for Mexico is almost zero, while South Africa’s is 1.4 percent, compared with the average 2 percent over the last decade.

Central bank rate increases in Turkey, India and South Africa last week failed to contain January’s 3 percent selloff in emerging-market currencies. Citigroup says yields are not high enough to attract capital needed to finance current-account deficits within some of those nations. Competition for capital is intensifying with the Federal Reserve paring monetary stimulus while the International Monetary Fund is calling for “urgent policy action.”

“When you have low real rates and try to finance your current-account deficits, it usually won’t work,” said Dirk Willer, a Latin America strategist at Citigroup, the second- largest currency trader, in a phone interview from New York on Jan. 31. “If the U.S. is repricing for higher rates, it’s very difficult for you to get away with lower rates. South Africa and Turkey are not safe yet.”

Global Exodus

Global funds pulled out $6.3 billion from emerging market stocks in the week through Jan. 29, the biggest outflow since August 2011, according to Barclays Plc., citing data from EPFR Global. More than $12 billion have fled the funds this year, already approaching the full-year outflow of $15 billion in 2013.

One-year real rates in emerging markets, based on the difference between interest-rate swaps and consumer price increases, are about 1 percent, according to Goldman Sachs. While rising, the rates are lower than average of about 2 percent between 2004 and 2013, a model at the New York-based bank shows.

Turkey’s central bank raised the benchmark one-week repo rate to 10 percent from 4.5 percent at an emergency meeting on Jan 28, one days after the lira fell to a record low of 2.39 per dollar. While the decision helped the currency rebound to 2.2565 per dollar last week, it is still down 4.8 percent in January, the worst start to a year since 2009.

‘Sudden Stop’

South Africa’s rand weakened to a five-year low of 11.3909 per dollar on Jan. 30, even as the central bank unexpectedly raised interest rate by a half percentage point to 5.5 percent. The currency declined 5.6 percent last month to 11.1326 per dollar. India’s rupee fell 1.4 percent last month as central bank Governor Raghuram Rajan surprised analysts by raising the repurchase rate to an 18-month high of 8 percent.

The Argentina’s government allowed the peso to devalue by 19 percent in January as private banks boosted deposit rates. In Hungary, the central bank bucked the trend, lowering the benchmark 0.15 percentage point to a record 2.85 percent on Jan. 21. The forint tumbled to a two-year low of 314.23 per euro.

“If policy-makers don’t respond appropriately to signals from the market, and very few in EM have done so convincingly so far, then asset prices continue to pressure the economy directly,” Manoj Pradhan and Patryk Drozdzik, London-based economists at Morgan Stanley & Co., said in a client report on Jan 27. “At extreme times, this results in a sudden stop,” or an abrupt halt or a reversal in capital flows into a country for an extended period, they wrote.

Trend Reversal

The rate increases are a reversal of the trend over the past five years as the Fed’s monetary stimulus pushed capital into their boarders, allowing central banks in emerging markets to cut borrowing costs. Cheap money encouraged consumption, widening trade deficits and fueling inflation.

Turkey’s shortfall in the current account, the broadest measure of trade and services, amounted to more than 7 percent of its gross domestic product, making the nation more reliant on foreign capital. Brazil’s consumer prices stayed above the central bank’s target since August 2010, eroding the competitiveness of the economy.

The real interest rate for Mexico is at 0.1 percent, compared with an average 2.4 percent over the past decade, according to data compiled by Bloomberg. At 24 percent, Argentina’s deposit rates are 4 percentage points below the annual inflation that opposition lawmakers reported.

‘Just Normalizing’

Now that the Fed is withdrawing the stimulus, the interest rates are not enough to compensate the risk for putting money into emerging markets, according to Goldman Sachs.

The U.S. central bank announced on Jan. 29 plans to pare the amount its bond purchases by another $10 billion to $65 billion, extending the reduction this year to $20 billion.

“For many EMs, moving to a sustainable pace of growth and reducing external imbalances requires a combination of weaker currencies and higher rates,” strategists led by Kamakshya Trivedi at Goldman Sachs, in a Jan. 30 note titled “It ain’t over ’til it’s over.” “In most places, real rates are only just normalizing from extremely low levels.”

The rand, lira and real will weaken further, while the selloff may spill over to currencies with “stronger fundamentals,” including the Mexican peso, Hungarian forint and South Korean won, according to Trivedi.

Yield Premium

A Bloomberg customized gauge tracking 20 emerging-market currencies fell 3 percent to 89.3478, the worst start to a year since 2009. The index has tumbled 10 percent over the past 12 months, bigger than any annual decline since it slid 15 percent in 2008.

The premium investors demand to hold emerging-market local- currency debt over five-year U.S. Treasuries increased to 5.71 basis points, the highest since June 2012, according to JPMorgan Chase & Co.’s GBI-EM Global Diversified Index.

“The market will have to start differentiating these countries which have already experienced a significant exchange rate adjustment and those countries where the central banks would rather enjoy lower interest rates for longer,” Anders Faergemann, a senior portfolio manager, at PineBridge Investments in London, said in an Jan. 31 e-mailed reply.

The IMF said in a statement Jan. 31 that some developing countries need to take action to “improve fundamentals.”

Chinese Demand

A decline in U.S. Treasury yields last month provided little relief for emerging market currencies as China’s $4.8 trillion in shadow-banking debt raised concern about the growth outlook for a country that buys everything from Chile’s copper to Brazil’s iron ore. Exports from developing countries will grow 5.8 percent this year, compared with an average 7.3 percent over the decade through 2013, according to the IMF forecast.

The lack of export growth means raising interest rates to cut consumption and imports are the only way for countries such as Turkey and South Africa to reduce their trade deficits, according to David Lubin, head of emerging-markets economics at Citigroup.

Higher interest rates, in turn, will erode corporate earnings and slow economic growth, dimming the allure of their currencies, said Lubin.

“Having ‘won’ tighter monetary policy from these countries, the market is now faced with a new problem,” wrote Lubin in a client note on Jan. 30. “How to price these countries’ currencies when their growth outlook has taken a turn for the worse? And so, it is difficult to call an end to currency adjustment in EM.”

--With assistance from Wes Goodman in Singapore, David Goodman in London and Katia Porzecanski in New York. Editors: Dave Liedtka, Robert Burgess