We believe that we are closer to the beginning than to the end of the global currency ‘moment’. The global equity market rally in the past few days may continue in the near term. But this, in our view, will offer investors a great opportunity to hedge against the risk of further EM currency weakness. We do not share the popular view that the IMF’s newest facility – Short-Term Liquidity Facility (SLF) – is a ‘game-changer’. Rather, we believe that it will only have marginally positive effects on EM currencies not powerful enough to offset the strong headwinds to buffet EM currencies in the coming two quarters or so. There are also lessons from the Asian Crisis that are relevant in the EM discussion. Our Thesis on EM Currencies We have been bearish on Asian currencies since May 1, 2008, and warned in July about an impending sell-off in Latin American currencies (BRL and MXN), to be followed by sell-offs in TRY and ZAR, along with the Eastern European (EE) currencies. This script has played out reasonably well. Our thesis on EM rests on three legs. First, EM corporates and other local entities were drawn into short-USD structured positions, due to an extended period of low volatility, USD weakness and a positive carry against the USD. In fact, much of the sell-off in EM currencies we’ve witnessed is, in our opinion, due to local corporates and other players unwinding these USD shorts. Second, the world’s capital flows (portfolio, FDI and loan flows) will likely fall sharply in 2009, as the global economy slows. This is a risk that is still ahead of us, not behind us. Third, this sell-off in EM currencies seems likely to prompt investors to reexamine the longer-term EM story – i.e., that EM economies will consistently generate superior growth. In fact, some of that story, in our view, was a derivative of booming global growth, in turn partly fueled by easy credit in the developed world. While several EM economies did enact significant and sustainable structural reforms that have contributed to their recent outperformance, in our view, at least part of the story is traceable to global rather than country-specific factors. This Thesis of Ours Is Being Challenged The rally in global equities in recent days has made some investors doubtful of our thesis on EM. In contrast, we see this rally in risky assets as a good opportunity for investors to curtail their exposure to EM. In other words, as long as the global economy is decelerating, and especially the ‘second derivative’ of global output is negative, investors should sell EM currencies on rallies, not buy them on dips. We Are Unconvinced That the IMF’s SLF Is a ‘Game-Changer’ The IMF’s newest facility and the Fed’s swap lines announced last night have also added to the positive sentiment towards EM. We are unconvinced that the SLF is a game-changer. Having more dollars can’t hurt in this environment. But the irony here is that many of the ‘good’ countries (Brazil, Korea, Mexico and India) already have a lot of reserves (the three countries have a total of more than US$800 billion in official reserves). We need to ask why these reserves have not prevented their currencies from weakening, and why people think that another US$60-100 billion from the IMF will do the trick. Our answer to this question is that the global economic fundamentals are deteriorating rapidly. Global fundamentals will drive EM currencies, not country fundamentals. This is why we believe that the IMF’s SLF will help but ultimately will have a marginal effect, and will certainly not stop the depreciating trends in EM currencies. While we think that this facility is sensible, we doubt that it will fully offset the gale-force global headwind impinging on the EM economies. We may need to tweak slightly some of the FX forecasts, but we believe that EM currencies are heading lower as the world falls into a deep recession, regardless of whether the country in question is good, bad or ugly. Here are some specific thoughts we have on the SLF. 1. The IMF's SLF versus the Fed's swap lines. The two are clearly different facilities. The IMF’s SLF is essentially a three-year boost to the borrowing countries’ official reserves, to be repaid of course. On the other hand, the Fed’s swap lines are just that: they make no net difference to the overall abundance of official reserves, but will help if a country has ‘liquidity issues’ with underlying assets such as Agencies on which they might not want to take losses. The swap lines essentially permit EM central banks to hold their underlying assets to maturity, which is important to some central banks with large holdings of Agencies and MBS. Of course, there might be reasons to think it is also in the US interest to avoid ‘fire sales’ of US Agencies or MBS by foreign central banks. 2. These facilities should help to limit the undershoot in the EM currencies. Having more dollars is clearly a good thing. 3. But many of these countries already have a lot of foreign reserves. Let’s take Russia as an example. It started out with US$600 billion in reserves, which have been run down to possibly US$485 billion or so now. That’s still a lot of money. We need to ask why US$600 billion was barely enough to cap the pressures on RUB, and why US$485 billion will not be enough to avert a RUB depreciation. Not too long ago, India had US$400 billion in reserves. Yet USD/INR has risen from 40.0 to 50.0. We need to ask not just why this has happened, but also why this was allowed to happen when the RBI had so much in reserves? Further, Korea had, according to the latest data available, US$240 billion in reserves. Why did Korea permit USD/KRW to rise from a little more than 1,000 to 1,400, when it had so much in reserves? One possibility is that a meaningful portion of their reserve holdings are not in very liquid assets or assets they would take a loss on if sold. Another possibility is that the policymakers either prefer to allow some currency depreciation to help shield them from the shock of a global recession, or may, for some reason, suspect that they may not be able to defend a hard line in the sand. In both cases, it is hard to see how another US$20 or so billion for each of these reserve-rich economies would be game-changers. 4. But EM currencies will still weaken substantially from here, due to fundamental reasons: global fundamentals, not country fundamentals. Global capital flows to EM could decline from US$750 billion a year to US$300 billion next year, in our view. All else equal, EM would need to ‘spend’ US$450 billion in 2009 just to keep their currencies from weakening. But if global growth slows, the economic fundamentals of EM will deteriorate, which will naturally drive their currencies weaker, or persuade the policymakers to allow their currencies to depreciate. IMF a Game-Changer? A Historical Perspective While interventions by the IMF are major deals during EM crises, the announcements of IMF programmes more often than not have had little impact on the currencies in question. Let’s recap what happened during the Asian Crisis. The IMF announced Stand-By Arrangements (SBAs) with Thailand in August 1997, Indonesia in November 1997, Korea in December 1997 and the Philippines in April 1998. With the sole exception of Korea, the currencies continued to depreciate sharply, for an extended period, after the IMF initiated SBAs. Over the ensuing years, IDR, PHP and THB never really recovered much of the valuation losses, even with the IMF programme. The KRW was able to rally hard mainly because of the sharp turnaround in its C/A balance – a swing of more than US$30 billion from 1997 to 1999. However, during that period, the global economy was reasonably robust, allowing export-oriented economies to capitalise on their cheaper currencies. This time around, the entire global economy is likely to remain very weak, making the KRW experience difficult to be repeated, in our view. In short, IMF programs may be game-changers for the economies in question, but they were very ineffective in altering the trajectories of the exchange rates. Bottom Line We remain very worried about EM currencies, and believe that investors should sell into short-term rallies in the underlying assets and EM currencies so as to hedge against further EM currency weakness. The IMF’s latest facility and the Fed’s swap lines will provide marginal support for selected EM currencies, but will not be big enough to fully offset the powerful forces of a global recession pushing EM currencies lower from here.
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An Even Bigger and Broader Dollar Smile
November 03, 2008
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions We have been bullish on the dollar since last December, and started warning about severe stress in the EM currencies in May. The dollar’s recent rally has exceeded our expectations and we trust that the market is telling us that the forces we had identified as assisting the dollar may be more powerful than we had thought. We are thus revising up our USD forecasts to reflect this realisation. We believe that investors will likely start to assume that the global economy will head into a deeper recession than we had envisaged – probably something as severe as the one we saw in 1982, when the world grew by only 1%. As a result, cross-border risk-reduction is likely to continue. We believe that this trend of general deleveraging will be very powerful for much of the rest of the year and will be positive for the dollar. Emerging markets (EM) economies will likely be severely stressed, as will their currencies, with negative feedback effects on the developed world, particularly Euroland and the UK. All of these pressures will, in our view, force the dollar even stronger – the ‘Dollar Smile’ idea. We now see EUR/USD reaching 1.15 by end-2008 and 1.20 by end-2009 (compared to 1.30 and 1.25 previously), with an intra-2009 low of 1.10. In fact, if the global recession is severe enough, we would not rule out parity for EUR/USD. USD/JPY will likely remain very heavy as the world slows. Our new targets are 90 and 100 for the end-years (compared to 96 and 108 previously), with an intra-2009 low of 85. Why We See a Bigger and Broader ‘Dollar Smile’ Here is a summary of the arguments we’ve put forward in the past. We believe that these forces will remain USD-positive for the coming 3-6 months or so, as the world slows. The dollar might give back some of its gains when the world economy starts to recover, though. But that is a topic for discussion later. • USD positive factor 1. The world is still short the dollar. The world had been selling the dollar for six-and-a-half years, buying the euro and EM assets. Just like other trends we have witnessed in the past seven years, the reversal of the US credit cycle will likely lead to an unwind in these USD shorts. The size of the USD shorts, before EUR/USD began to sell off in July, had not been fully appreciated by investors. But the strength of the recent dollar rally suggests to us that the world remains short the dollar. • USD positive factor 2. Safe haven flows from EM. Stresses and strains in EM are more positive for the dollar than for the EUR or GBP. Not only was the dollar the funding currency in much of the capital flows into EM, but EM investors also tend to view the dollar as the safe haven currency in times of stress. This is why, historically, EM currency crises almost always involved large dollar purchases by EM investors. • USD positive factor 3. G6 converge to the Fed. The rest of the G7 will likely catch up to the Fed in rate cuts, and this should remove yet another dollar-negative. Given that the labour market tends to lag the economic recovery, wage pressures are unlikely to be a major concern for central banks. (To the extent that the UR is used for Taylor Rule calculations, the implied neutral policy interest rates could stay low for some time.) In addition, the sharp decline in oil prices (54% from the peak, and 21% from a year ago) will add to the disinflation/ deflationary pressures, allowing the G7 central banks to push their policy rates toward zero. In other words, ‘G7 ZIRP’ is now a distinct possibility, in our view. • USD positive factor 4. Euro zone’s structural integrity in question, due to stress in EM. As we argued in Europe More Exposed to EM Bank Debt than the US or Japan (October 23, 2008), pressures in EM, particularly Eastern Europe (EE), will likely stress-test the structural integrity of Euroland. The lack of a zone-wide Treasury and cyclical divergence within the zone will likely raise more questions about the durability of the monetary union. While we believe that a break-up scenario has a very low probability of occurring, we recognise that there will be legitimate reasons to question the functioning of EMU. After all, this is the first time since its birth that the EMU is being stress-tested. • USD positive factor 5. A fundamental improvement in the external financing outlook of the de facto dollar zone. We made this point in De Facto Dollar Zone versus De Facto Euro Zone (October 16, 2008). With oil prices being so much lower now than three months ago, the US oil trade deficit (which reached 3.0% of GDP recently) will likely fall sharply, allowing the improvement in the US non-oil trade balance to be better reflected in the overall trade data. At the same time, the external financial needs of the de facto euro zone are deteriorating and will become worse than that of the de facto dollar zone in the coming quarters. ‘De-leveraging’ versus ‘Liquidation’ While the financial markets may be experiencing intense effects of ‘de-leveraging’ (i.e., shrinking of balance sheets by investment banks and hedge funds), real money accounts such as pension funds, life insurance companies as well as SWFs that don’t use leverage will also likely to start to liquidate their holdings. (By the way, there is a sharp change in the SWF story, with the SWFs possibly turning into sellers of risk assets in the coming months.) The two concepts are distinct and the timing of the two waves of sales of risk assets is likely to be asynchronous, we suspect. Especially in EM, we believe that there will be further waves of liquidation of positions from EM, as the global economy slows. (Regarding the volatility in global equities, we suggest that investors exercise care in not exaggerating the role of P/E in justifying buying or selling strategies. Whether or not equities are expensive depends on a whole host of considerations, such as uncertainty and the discount rate. P/E ratios could be low to reflect a high uncertainty premium. P/E ratios could also be distorted by a rise in the effective discount rate that exaggerates the decline in earnings in the very near future. In any case, based on the experience in the US since 1929, equities tend to rally about three months before the end of the recession. We are unconvinced that the end of the global recession is already in sight.) The IMF’s SLF Last night, the IMF announced a new facility – the Short-Term Liquidity Facility (SLF) – that has no to low conditionality and access to up to five times the countries’ quotas. On the same day, the Fed announced a series of bilateral swap arrangements with some EM central banks. Our view is that, while having more dollars is clearly a good thing, these flows will likely not be nearly big enough to fully offset the gale-force headwinds that are likely to impinge on EM. In short, the impact of the IMF’s SLF is likely to be marginal, not a game-changer, as far as the trajectories of the EM currencies are concerned. Bottom Line We believe that the world is still short the dollar, and further ‘deleveraging’ or ‘liquidation’ of cross-border positions – likely if the world is indeed falling into a deep recession – will ultimately be dollar-positive. We now see even more upside for the dollar in the coming 3-6 months, against most of the majors and almost all of the EM currencies. Appendix 1: Japanese Yen If risky assets sell off again, against the dollar and possibly also against the euro, and if the yen strengthens significantly, those developments could prompt FX market intervention. These prospective interventions, however, are unlikely to reverse the trends in USD/JPY or EUR/JPY. As global demand slows, pressures on Japan will mount. The impact of a global recession on Japan’s exports is clear. Lower oil prices could push Japan’s CPI back below zero in the coming months. Our Japan watcher Takehiro Sato was early in warning about a recession in Japan, and remains bearish on the outlook of the Japanese economy. We suspect that rate cuts by all G7 central banks, including the BoJ, towards ZIRP make a lot of sense, or at least this is the direction investors should expect them to move. However, for Japan, the room to cut is very limited. While Japan will also likely resort to fiscal stimulus, as it always has in the past, the exchange rate should be an increasingly relevant issue, and the risk of unilateral interventions will rise as the economy slows and as the JPY stays strong. 1. REER of JPY already very weak. Some argue that the real effective exchange rate (REER) of the JPY is still very weak from a historical perspective, and therefore Japan has no case to intervene. We disagree. It is indeed true that the REER of the JPY is still about a third weaker than it was in 2000. But the key implication should be that, despite the super-weak JPY, Japan has only managed to eke out modest growth in recent years. The extraordinarily weak JPY in recent years and the export-reliant nature of Japan’s growth suggest that Japan is not particularly well-positioned to weather this incoming storm, as our colleague Sato-san has argued. Thus, the fact that the REER is still low does not mean that JPY intervention is not justified. 2. Virtually all of Japan’s export markets are slowing. Japan’s direction of trade has evolved over the years to become more reliant on exports to the BRICs, and relatively less to the US (the share of exports to the US has shrunk from 28.1% to 20.4%). However, all of Japan’s major markets – the US, BRICs, EU and AXJ – are showing a material slowdown. Japan’s monthly trade figures showed the first deficit in 26 years, followed by a minuscule surplus the following month. The trade surplus could be re-established, but only through import compression, which is bad news, not good news, for Japan. 3. EUR/JPY is a major problem for Japanese exporters and institutional investors. From its peak, EUR/JPY has fallen by 24%. This poses a serious problem for Japanese exporters and institutional funds that have had large exposure to EUR assets. The fall in EUR/JPY is a bigger problem than the fall in USD/JPY. This is why we suspect that, if the MoF intervenes, it might even intervene in both USD/JPY as well as EUR/JPY. 4. Repatriation flows are very powerful. Given the severity of the global shock, repatriation flows back into Japan are very powerful. We are not sure that unilateral interventions will succeed in reversing the trend decline in the JPY crosses.
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