While the American economy was under pressure and its Quantitative Easing policy pumped money into the global economy faster than it could be spent, all was well with Emerging Market currencies like the Rand. Forex desk jockeys in London and New York borrowed greenbacks at low interest rates to reinvest them in Emerging Market countries where the rates were higher. That is the so-called “carry trade” – an easy way to make money as long as the Dollar doesn’t appreciate and wipe out the difference in the cost of borrowing and investing. With QE in full blast there was little chance of that. But as this excellent article from today’s Financial Times explains, what has been a virtuous cycle for currencies like the Rand, can quickly reverse. When this hot money leaves, the impact on domestic interest rates and economic growth is stark. Pressure to reverse the carry trade is reaching boiling point. The risk of another Rand collapse is growing. Â – AH Â
By James Kynge of the Financial Times:
The term “carry trade” sounds innocuous, even benign. But as the US dollar continues to surge, the multi-trillion dollar flow that has engorged emerging markets risks reversing, threatening growth in much of the developing world, analysts have warned.
Investors engaging in the carry trade borrow in a low-interest currency such as the US dollar to invest in the higher-yielding domestic debt of emerging markets. But stress on the carry mechanism is mounting, with a gauge of EM currencies – the JPMorgan EMCI index – plunging to its lowest point against the US dollar in 11 years.
Investors may soon decide that their losses in the foreign exchange market eclipse their gains from the interest rate differential, prompting them to cut and run. Were market participants to unwind their carry in unison – selling EM assets to buy dollars – this process would exacerbate the market conditions from which they were fleeing.
Several analysts sense danger. “The carry trade strategies are finally cracking,” said Luis Costa, currency strategist at Citi, a bank. “The market has been so flooded with liquidity and interest rates have been so low for so long, but this is turning now.”
David Hauner, strategist at Bank of America Merrill Lynch, sees a lengthy market correction in prospect. “It is very clear that this isn’t the end of the carry trade forever, but it is a correction,” he said.
The headwinds eviscerating the carry are reinforced by a robust outlook for the US dollar caused by three enduring trends: the US economy is recovering strength, boosting the greenback’s attractiveness; the US Federal Reserve is set to end its programme of quantitative easing in October, tightening dollar liquidity; and finally, the European Central Bank has embarked on a dovish phase of monetary policy, enhancing the dollar’s outlook relative to the euro.
The effects of a shift in sentiment away from EM local currency bond markets is already visible. Last Friday, the JPMorgan GBI EM local currency bond index was nearly 6 per cent lower than its year high at the end of July. Average yields have hit 6.69 per cent, up from a 6.45 per cent year low in July.
Issuance of local currency debt has also slowed, with just $22bn in bonds launched, compared with a monthly average of $62bn over the past year, according to estimates by the Institute of International Finance.
Such figures expose the vulnerability of several EM economies that rely on carry trade inflows not only to keep domestic interest rates low, but also to finance current account deficits, fund infrastructure projects and keep companies flush with cash.
A sudden withdrawal of the carry trade risks having a profound impact on their economies. Though the magnitude of the EM carry trade is not known, estimates suggest that $2tn in overseas capital is invested in local EM debt. This is slightly larger than the size of the Indonesian and Mexican economies combined. Total foreign ownership in local EM bond markets has risen from 8 per cent to 17 per cent between 2007 and 2012, according to the Bank of International Settlements.
Some countries are particularly exposed to the carry’s fickle fortunes. In Malaysia, the proportion of government bonds under foreign ownership has risen to a level of over 45 per cent. It is more than 35 per cent inPoland, Hungary, Mexico and Indonesia. The measure of a nation’s vulnerability to the withdrawal of carry flows lies in the differential between local and US dollar interest rates when judged against currency futures prices. According to this measure as calculated by Citi, carry investors in Israeli shekel and Czech koruna debt would be facing losses.
Despite the concerns, some investors remain sanguine. “The tightening in EM financial conditions will test the resilience of local bonds as an asset class,” said Gerardo Rodriguez, portfolio manager at BlackRock, an investment management company.
“But we are not seeing a disorderly unwinding of the carry trade.”
CURRENCY SELL-OFF – Slowing China and US rate prospects spark jitters
A sell-off in emerging markets currencies deepened yesterday as political concerns exacerbated fears many countries will suffer a double blow of slowing growth in China and rising interest rates in the US.
The Brazilian real sank to its lowest level against the dollar since 2008 after polls showed President Dilma Rousseff – whose interventionist economic policies have unnerved investors – gaining on her opponents ahead of Sunday’s presidential poll.
Russia’s rouble, down 20 per cent since the start of the year, slid further, nearing the level that would trigger central bank intervention.
But the problems have also begun to hit emerging markets that do not suffer from considerable political risk. Indonesia’s central bank said it had intervened to limit a sharp fall in the rupiah, which lost more than 1 per cent against the dollar, hitting a seven-month low. The Mexican peso and South Korean won are among the worst performing currencies over the last week, while the Turkish lira and South African rand have fallen to their lowest levels against the greenback since late January. By one gauge – JPMorgan’s EMCI index – emerging market currencies have fallen below their 2007 nadir.
Emerging markets that came under intense pressure in 2013, when the US Federal Reserve first said it would taper its asset purchase programme, face turmoil as investors factor in the likelihood of US interest rates rising next year. Emerging markets are also vulnerable to a Chinese slowdown that will hit regional trade partners and commodity producers.
(c) 2014 The Financial Times Limited
