This announcement – logical in view of US economic growth – was also meant to prepare investors for gradual monetary tightening, which culminated in the interest-rate hikes at the end of 2015. But Bernanke's statement was a severe blow for emerging-market currencies, as it meant a reduction in liquidities being injected into the financial system. The results are clear: to date, all of these currencies have depreciated against the dollar. While they have all gone down, some have dropped more than others.
The extent to which a given currency was affected depends on the state of the country's current accounts. (Current accounts indicate, among other things, the balance of trade, which is the difference between a country's imports and exports. A current-account surplus means that a country is a net lender to the rest of the world.) The currencies of countries carrying a current-account deficit were hit harder than those of countries with a surplus. The Fed's remarks signalled a drop in the international capital needed to refinance these countries' deficits. Asian countries with high exports saw their currencies lose little ground to the dollar, while countries with a current-account deficit – and which may also have had a high exposure to commodities – saw a steeper drop in their currencies (see chart).
An alternative approach to this question, through effective exchange rates, paints a similar picture. (The effective exchange rate is a weighted average of a country's currency relative to the currencies of its trading partners. ) Looking at historical valuations, Asian currencies are the most expensive while the currencies of countries that run a current-account deficit and/or that export commodities are significantly cheaper (see chart). This wide disparity suggests that it may be overblown. Did the current-account situation alone underpin the favour shown to Asian currencies? Does this factor alone still justify these currencies' valuation premium? Probably not. The Fed's monetary tightening cycle has begun, and the relevant factors are now to be found elsewhere, including in China.
Beijing has issued a growth target that appears overly ambitious in view of an economic slowdown that looks set to last. And the fact that the government is keeping expectations high by "freezing" the 2016 growth target at 6.5-7% increases the likelihood of disappointment. In addition, although the renminbi has stabilised recently, it should resume its downward path against the dollar, which will in turn put further pressure on the currencies of its main trading partners.
Using these two variables, we are able to identify highly valued currencies – a legacy of their countries' current-account surplus – that are exposed to the uncertainties of China's growth and currency.
The Philippine peso and the Thai baht benefited from the relative safety provided by their current-account surplus. These currencies are expensive in terms of effective exchange rates, while their export breakdown by country reveals significant exposure to Chinese-related factors (see charts). The moderate value added of these exports (often assembly components) will be hurt by downward pressures on the renminbi, which tend to drive up the cost of products imported by China. These currencies will therefore come under real pressure. Indeed, since the summer of 2015 when the renminbi was unexpectedly devalued, these currencies have been more sensitive to moves by the renminbi. In addition, both Thailand and the Philippines face some political uncertainties in the form of a constitutional referendum in July and a presidential election in May, respectively.
Inversely, currencies with a low valuation – because they are overly penalised by a current-account deficit – and low exposure to all things China now stand out. The Mexican peso is the best example.
- With 80% of its exports going north of the border, Mexico has few direct links with the Chinese behemoth. Its manufacturing sector, which is currently being driven by reindustrialisation, is among the most dynamic among emerging markets (see left-hand chart below). The country's links to the USA also take the form of workers' remittances to the home country. These remittances, which account for 2.5% of the country's GDP, have a real impact on consumer spending. The country's consumer spending should receive a further boost from the strong US labour market (see right-hand chart below). Notably, Mexico is one of the only major emerging markets to undertake needed structural reforms.
Although the outlook for emerging-market equities is modest in 2016, investors can find opportunities in related asset classes, including currencies.