Emerging Market FX: Global versus Domestic Factors

US and global growth expectations have been revised higher but with rising US Treasury yields, could that end up as a mixed bag for EM currencies, as a large fiscal expansion unfolds in 2021 in the US?

To answer this question, we ran an update of our Principal Component Analysis (PCA) methodology which helps assess the impact of the global environment on EM currencies.

EM currencies overall are not yet fully discounting the prospect of global growth recovery or rises in commodity prices and a number of EM currencies display very cheap valuations. The case for EMFX remains strong but differentiation has increased. In EM economies where rising inflation combines with increased sovereign risk, we see currencies as particularly vulnerable to higher US Treasury yields.

On our measures, the Turkish Lira (TRY), which is so far the best performing currency year-to-date, has strengthened more vs. US dollar than could be justified by global factors* (see chart 1). Additional TRY gains likely rely on further improvement in domestic fundamentals, including the curbing of inflation and reducing the dollarization of residents’ deposits. The commitment of the Central Bank of Turkey to a tight monetary stance has been the first step. We believe this could be tested by the need to raise rates, as inflation has yet to peak in view of pipeline pressures reflected in PPI data.

The Brazilian Real (BRL), currently the worst performing EM currency year-to-date, is under-pricing the positive impact from the global environment (see chart 2), mostly commodity prices. Upside surprises on inflation have acted as headwinds for BRL and they combined with heightened uncertainties surrounding the fiscal outlook, mainly related to the pandemic. Progress in containing the virus spread and early tightening of monetary policy as soon as May could provide domestic catalysts for a BRL rebound closer in line with global factors, including commodities.

Indian Rupee (INR) is in line with global factors which leaves it firmly driven by the fine balance between growth support and financial stability. That remains a net positive for INR at this stage in our view, as the Reserve Bank of India (RBI) keeps the inflation targeting system intact while accommodating fiscal expansion. But with our estimate that USD/INR is in line with what is implied from global factors, this leaves little buffer for a deterioration in domestic fundamentals (for instance a premature cut in policy rates).

The Korean Won (KRW) has underperformed other EM Asian currencies year-to-date, reflecting large resident equity outflows. We find that this now leaves KRW vs. USD at a significant discount compared to global factors (see chart 3), making it attractive at a time when strong demand and high prices for semiconductors benefit Korean exports.

Another highly cyclical EM currency, the Mexican Peso (MXN) has also lagged the improvement in global factors, based on our PCA analysis (see chart 4). While a headwind for growth, the restrictive monetary stance of Banxico, combined with a large trade surplus, points to MXN gains vs. USD ahead.

*Global factors include equity and credit markets, commodities, USD index, US Treasury bonds.

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Keywords: EMFX, currency management, EM currencies, inflation, pandemic.

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