February 14, 2014
T. Rowe Price portfolio managers and analysts are carefully monitoring the volatility in emerging markets currencies, where last year's selling pressure has intensified in early 2014. The currencies of the emerging markets with the largest current account and fiscal budget deficits—India, Indonesia, Turkey, Brazil, and South Africa—have experienced the largest declines. We believe that the currencies of some developing countries are now at levels that underestimate their ability to make the reforms necessary for healthy future economic growth.
Selling pressure on emerging markets currencies started in May 2013
- Many emerging markets currencies fell significantly against the U.S. dollar in 2013. The South African rand, for example, lost 19% against the dollar last year, and the Brazilian real dropped more than 13%. The selling pressure on emerging markets currencies picked up again in January 2014, and some developing countries took steps to defend their currencies, including intervening in foreign exchange markets and raising benchmark lending rates.
- Ongoing volatility in emerging markets currencies has broadly affected all global markets as investors have retreated from riskier asset classes such as emerging markets equities and debt. Our economics team and our international and emerging markets bond portfolio managers have been carefully monitoring the foreign exchange market.
Supply and demand, relative interest rates, and central bank intervention affect foreign exchange market
- Broadly, supply and demand for a currency set foreign exchange prices. Demand for assets denominated in a particular currency increases demand for that currency. For example, a U.S. investor who wants to buy a bond or stock in Turkey first needs to buy the lira with dollars and then purchase the asset. When selling the bond or stock, the U.S. investor sells the asset to receive lira, which the investor then sells in exchange for dollars.
- Relative interest rates also affect currency prices. With all else equal, there will be more demand for the bonds—and thus the currency—of a country that offers higher interest rates than other nations. This is why countries will sometimes raise benchmark lending rates in an effort to strengthen their currency. However, higher interest rates can also weigh on a country's economic growth.
- National central banks can also intervene in foreign exchange markets by using currency reserves to try to raise the value of their currency (by purchasing local currency with foreign reserves) or lower it (by selling local currency and receiving foreign currencies).
Currencies of the "fragile five" countries fall the furthest as a result of their current account deficits
- The sell-off in emerging markets currencies began in May 2013, when the Federal Reserve made statements about eventually reducing the pace of its asset purchases. Longer-term U.S. interest rates rose quickly. This decreased the attractiveness of emerging markets currencies relative to the dollar. In addition, Fed tapering is reducing the amount of liquidity being added each month to the global financial system, removing some of the incentive to invest in riskier emerging markets assets.
- The selling pressure on the currencies of developing countries formed a downward spiral in the summer of 2013, as the falling currencies triggered outflows from emerging markets, which caused emerging markets currencies to fall further.
- Although almost all emerging markets currencies fell, the fragile five—India, Indonesia, Turkey, Brazil, and South Africa—were hardest hit. These countries have large current account deficits (they import more than they export) and fiscal budget deficits, so they are dependent on inflows of foreign currencies to finance their "twin" deficits. Essentially, they need foreign currencies to pay for their imports and government spending.
- In addition, concerns about slowing economic growth and accelerating inflation in emerging markets—even those that are not part of the fragile five—began to build, further pressuring the currencies.
T. Rowe Price analysts believe that investors have sold emerging markets currencies indiscriminately and that country-specific analysis is essential
- T. Rowe Price analysts and portfolio managers believe that investors have sold emerging markets currencies indiscriminately. Our country-by-country analysis reveals that some currencies appear to be at levels that underestimate the ability of particular nations to make the economic, structural, and political reforms that are necessary for continued healthy economic growth. In our view, Mexico is a good example of a country that is implementing the reforms designed to support its currency, the peso.
- While we expect some near-term volatility in emerging markets currencies, we don't think that there will be a broad emerging markets meltdown like the Asian crisis of the late 1990s. The generally solid fiscal positions and healthy economies of developing countries relative to developed nations should help prevent the contagion in emerging markets assets that has formed in the past. In addition, most emerging countries no longer try to hold their currencies at a fixed exchange rate to the dollar, which was a major contributor to the problems of the 1990s.
Identifying opportunities and risks on behalf of our clients
- Our extensive sovereign credit, international economics, and equities research capabilities, and the global collaboration across those research platforms, give us a critical edge in analyzing both risks and investment opportunities in emerging markets currencies.
- For example, Andrew Keirle, a London-based fixed income portfolio manager, traveled to Turkey for meetings with government officials before and after the Central Bank of Turkey's unusual midnight announcement on January 28 that it would dramatically raise interest rates.
- Applying this research, T. Rowe Price's international and emerging markets bond portfolio managers are actively positioning their portfolios to mitigate unnecessary exposure to the emerging markets currencies that they believe are most at risk of further declines, while boosting exposure to those that are poised to appreciate over the medium to long term.
- Despite the recent sell-off in emerging markets debt, many of its attractive features—including solid credit quality, relatively attractive yields, and strong diversification potential—remain intact. We believe that, while these benefits will support inflows and total return potential over the long term as global fixed income investors address underinvestment in emerging markets, investors need to be prepared for the volatility and risk inherent in this asset class.
This information reflects the opinions of T. Rowe Price and is based on current market conditions as of February 3, 2014, and is subject to change without notice. This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.