While assessing Malaysia’s simultaneous FX, stock, and bond market meltdown on Friday we described the situation facing emerging market currencies as follows:
When China went the “nuclear” (to quote SocGen) devaluation route in a last ditch effort to rescue its export-driven economy from the perils of an increasingly painful dollar peg, everyone knew things were about to get a whole lot worse for an EM currency basket that was already reeling from plunging commodity prices, slumping Chinese demand, and the threat of an imminent Fed hike.
Indeed, moves like that seen in the ringgit (which has suffered its worst two-day decline against the dollar since 1998) have some commentators suggesting that an Asian Financial Crisis redux is now in the cards.
And while Asia ex-Japan currencies may face the most immediate risk, the pain from Beijing’s entry into the global currency wars will be felt acutely in LatAm as well. Take Chile and Colombia for instance where, as we detailed earlier this month, the pesos (respectively) have been under tremendous pressure over the course of the past year.
And of course there’s Brazil, where all roads lead to further devaluation as the government grapples with the worst stagflation in a decade as well as current account and budget deficits.
So where, one might ask, does that leave emerging markets? In other words, we’ve felt the initial shockwaves of China’s entrance into the global currency wars, now what can we expect going forward?
Nothing good for Asian currencies, Morgan Stanley says. Here’s more from the bank’s global currency research team on which countries have the most to lose.
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From Morgan Stanley:
Much of EM is vulnerable to the weaker CNY. The impact is likely to be transmitted through three channels: i) Trade (both direct and indirect via third-party competition); ii) Commodities (given China’s role in supporting commodity prices over the past decade); and iii) Deflation (CNY weakness leading to greater disinflationary pressure elsewhere). These channels disproportionately impact AxJ currencies, largely through channels i and iii, as can be seen in Exhibit 4. SGD, TWD, KRW all have over 20% of their total exports exposure and over 10% of GDP dependent on manufacturing and electronics-based exports to China. While import demand from China has already been in decline, RMB depreciation makes imports from these countries less attractive.
For Korea and Taiwan, whose exports also compete with China, we think there is also a risk that China takes fiscal and monetary easing measures aimed at improving productivity. We think that such measures would increase the export competition to these countries from China. Worse hit would be the lowflation economies, and not coincidently, many of the high export-oriented economies are struggling with issues of structural overcapacity and PPI deflation – these currencies include KRW, SGD, TWD and THB, where PPI has been in deflation and CPI is negative or close to zero. With monetary policy in these economies already constrained by high leverage, central banks had shifted gears towards using FX adjustment as a tool against deflation. RMB, which has over a 15-20% weight in most of the regional REERs, had remained an anchor relative to which AXJ currencies could weaken and adjust their REERs. But, the weaker RMB now makes the REER depreciation for these currencies even more difficult, and we argue that AXJ FX will need to see a high beta reaction to RMB weakness in order to stabilize their REERs.
Outside AXJ, Where Does CNY Have Most Effect?
We expect the currencies most vulnerable to CNY dynamics to be those exposed through both trade and commodity channels. LatAm, notably CLP, PEN and, to an extent, BRL, stands out on this basis. In CEEMEA, ZAR is most at risk, in our view.
LatAm’s high exposure to commodity prices has already led it to be an EM underperformer. The recent pace of depreciation has been significant enough to drive official pushback from four out of five central banks in the region, with three out of five actively intervening. We believe that intervention is likely to limit the pace of depreciation, but not the direction, particularly if China concerns persist. CLP, PEN and BRL are the most at risk, in our view, given their exposure to industrial commodities.
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So in short, it will now be increasingly difficult for China's regional trading partners to tinker with their trade-weighted exchange rates and for the eight out of nine Asian (ex-Japan) countries already struggling with PPI deflation well, it's about to get worse. Meanwhile, LatAm's commodity exposure remains the channel whereby what happens in China most certainly does not stay in China, if you will.
Here's a look at how the currencies Morgan Stanley mentions as the most exposed have performed YTD and over the past week:
Not one to sit idly by without weighing in, Bill Gross is out with his own take on which EM currencies are "breaking":
Gross: (1 of 2) Global currencies fake it 'til they break it. Faking and Breaking not healthy for global markets.— Janus Capital (@JanusCapital) August 17, 2015
Gross: (2 of 2) Currently Faking: CNY, USD. Currently Breaking: BRL, KRW, MYR, IDR, ZAR, TRY, CAD, COP, RUB, PHP ... the list goes on.— Janus Capital (@JanusCapital) August 17, 2015
Finally, here's a bit more from Morgan Stanley on the effects of a weakening yuan on effective exchange rates around the region (this was mentioned above, but it's set out more clearly here):
Arguably, the impact of a RMB depreciation will be felt most keenly within the AXJ region, as China is a key trading partner for many economies in the region. As discussed earlier, the key channel of transmission would be through upward pressures on the region’s NEER, posing challenges in the form of adding to the tightening/deflationary pressures at a time when the central banks in the region are already slow to address the deflationary pressures. However, this added deflationary pressure could potentially be offset if policy easing measures in China brings about a meaningful improvement in China’s domestic demand, which would help to lift export growth for the other economies in the region.
As the RMB depreciates, the nominal effective exchange rates of economies in the region will likely be pushed up, given that the RMB accounts for anywhere between 14-28% in the trade-weighted basket for the economies in the region and the weight of the RMB in the region’s NEER is higher than that of the USD (see Exhibit 16). This appreciation of the NEER will add on to the deflationary pressures that the region is already experiencing. As it is, the NEER in the region excluding China has remained at 5-year highs despite some slippage at the margin (Exhibit 17), and eight other economies in the region (excluding China) already have producer prices in deflation and many of them for an extended period of time (see Exhibit 18). The bulk of the region’s leverage is concentrated in the corporate sector, and the loss of pricing power is therefore likely to hurt the corporate sector more in the form of weaker corporate profits and also higher real cost of debt servicing. The persistence of the PPI deflation over the past three years has meant that there are elevated risks that the PPI deflation will spill over to other sectors.
Ultimately, the path ahead is riddled with exported deflation and decreased trade competitiveness for a whole host of emerging economies. As we discussed at length in "Emerging Market Mayhem: Gross Warns Of "Debacle" As Currencies, Bonds Collapse," all of this is set against a backdrop of declining global growth and trade, a trend which many had assumed was merely cyclical, but which in fact may prove to be structural and endemic. If that's the case, things are likely to get far worse for many of the countries listed above before they get better.