Fran Rodilosso, Head of Fixed Income ETF Portfolio Management, CFA
October 01, 2018
While the recent emerging markets currency selloff has been painful for investors, there may be a silver lining for long-term investors in the asset class.
Emerging markets local currency bond investors have endured a loss of nearly 10% this year, driven almost entirely by foreign currency depreciation, as of September 21, 2018. About one-third of the J.P. Morgan GBI-EM Global Core Index is comprised of currencies that have lost more than 10% against the U.S. dollar, with the most extreme examples being the Argentine peso and the Turkish lira, down 50% and 40%, respectively. Only the Thai baht and Mexican peso have experienced (somewhat modest) gains this year.
But a depreciating currency can have a self-correcting impact on a country’s external accounts, and help to alleviate some of the pressures that may have sparked a selloff in the first place. For example, a weaker currency can help make a country’s exportable goods more competitive. A currency selloff also increases the cost of imports and dampens domestic demand, which can help cool an overheating economy. The overall impact can be to lower a current account1 deficit (or increase a surplus), helping to bring an economy into balance. For a country such as Turkey, which currently has an unsustainably high growth rate and a substantial current account deficit, the currency weakness can make a significant and rapid impact.
Turkey Current Account Improvement Driven by Currency Weakness
September 30, 2015 – July 31, 2018
Source: J.P. Morgan. Data as of July 31, 2018. Past performance is no guarantee of future results.
That is not to say that a rapid depreciation in a country’s currency in itself will provide sufficient support for a recovery, or that it does not have other, deleterious effects. The pendulum can certainly swing very far to the other side. As economic growth slows or contracts, and inflation potentially soars, the country may encounter significant economic hardship. This may compel it to spend some of its foreign currency reserves to defend its own currency against extreme weakness, which can further increase its need for near-term financing and, therefore, its vulnerability. Although the risk of default is much lower for local currency bond holders due to the money printing ability of a sovereign, credit risk increases for holders of external debt—for example, bonds denominated in U.S. dollars, as servicing these obligations becomes more difficult for the country. Further, and more generally, the rapid decline in a currency can create conditions that are conducive to hasty policy decisions (increasing the risk of a policy mistake), political changes, and societal unrest.
Nevertheless, assuming appropriate policy responses by governments and central banks, improved external balances can provide support for impacted currencies, all else equal. Several years ago the market witnessed such a recovery among various emerging economies, including South Africa, Indonesia, and Turkey, part of the “fragile five”. With fundamentals that are generally better in most emerging markets compared to other past periods of currency volatility, investors can take some comfort in knowing that the recent pain from currency depreciation may help to set up conditions for a recovery. As Turkey in particular has proven, however, a country must implement and continue to pursue monetary and fiscal policies that foster the long-term health of the economy and not short-term political gain.
IMPORTANT DEFINITIONS AND DISCLOSURES
1Current account is a record of a country’s transactions with the rest of the world, based on its net trade in goods and services, net earnings on cross-border investments, and net transfer payments.
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J.P. Morgan GBI-EM Global Core Index is comprised of bonds issued by emerging market governments and denominated in the local currency of the issuer. Country weights are capped at 10% and have a floor of 3%.
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