There are good reasons why emerging markets are back in fashion. Here we focus on recent developments and long-term macroeconomic trends that have been shaping a new risk landscape for the EM asset class.
The key factor for explaining the behaviour of EM currencies is non-resident capital flows. Such flows have come in three distinct long-term waves over the past 40 years, each of which has consisted of several years of surges in flows followed by a similarly long period of declines.
Many financially open EMs drowned in the decline phases of the first two waves — in 1982-1989 (which led to the Brady plan for indebted countries) and in 1997-2001 (marked by Argentina’s default in 2001). The declines led to abrupt currency depreciations that triggered negative feedback loops in which currencies, spreads and even deposit withdrawals spiralled out of control, causing deep recessions.
The decline phase of the third wave — in 2011-2016 — was particularly harsh. Non-resident capital flows experienced their largest ever decline while many EMs were buffeted by a 40 per cent average reduction in commodity prices. But although this decline constituted the mother of all stress tests for EM balance of payments, the outcomes of the shock were stunningly better than in the previous declines of flows.
EM currencies — as well as economies — proved they could float more smoothly than the past in the wake of the third wave. With only a few exceptions, they avoided sovereign and banking stresses and recessions.
Against this backdrop, it became apparent to investors that their EM exposures, including currencies, were subject to a much lower crash risk. Central bankers overcame their fear of floating, becoming more inclined to use their currencies as shock absorbers than they had previously done. Volatility increased in some cases. But when currencies slid, they did so less dramatically than in the past.
These dynamics represent a new era in which the EM asset class has come of age. In 2011-2016, the maximum one-month depreciation among many EM currencies was no greater than that of the euro or the Australian dollar.
Nonetheless, there are downside risks for investors. First, short-run EM currency volatility is now higher than in the past, and comparable to developed markets’ currencies (with China a key exception). Second, investors have less scope for diversifying risk across EM currencies. The increased presence of global investors in EMs has, along with greater currency flexibility, led to a significantly closer connection between EM currencies and shocks originating in global financial centres.
Since the most recent global financial crisis, just five factors — stocks, bonds, currencies, VIX and the strength of the US dollar against major currencies — can account for more than 80 per cent of the total EM currency index movements. Country-specific factors, it seems, matter much less.
What to expect in the new age for EMs?
In our view, the lower crash risk, higher variance, higher cross-asset correlations and the correlations within EM currencies are all here to stay. The changes in policy framework will probably be permanent.
The incentive for EM central banks to use exchange rates to absorb external shocks has increased because of two trends. First, the decline of pass-through of currency movements to inflation seen before the global financial crisis has not reverted. Second, currency mismatches within sovereign balance sheets have stayed much lower than in the past.
With currencies causing less instability, most EM central banks are unlikely to revert to using more heavily managed floats that could result in currencies with temporarily low variance that could eventually blow up.
There is certainly no shortage of potential threats to the EM world. These include pockets of very high corporate debt, the spectre of protectionism and China-related reversals. But lessons from the past lead us, on balance, to be optimistic about the future.
History shows that sustained momentum, such as the one EMs are enjoying now, represents a particularly strong force for maintaining EM flows and currency valuations into the future. This momentum is probably the start of an extended surge of flows in another long-term wave.
Depreciation of EM currencies is not required for macroeconomic adjustment to take place. Valuations in real effective terms are on average still below trend, and current account balances have tended to adjust. Furthermore, net capital flows have plenty of space for a recovery and are still well below their historical average.
For over 40 years, investors from developed markets have systematically piled into EM assets (on a yearly basis, and with varying degrees of intensity), as they rationally try to reduce “home bias” in their portfolios. The current political environment suggests there are few reasons for investors to alter course.
Guillermo Tolosa is economic adviser to Oxford Economics.