Some emerging-market implications

On a net basis, futures speculators have not been long yen (or Swiss francs, for that matter) since last June. This may also be a helpful guide of the so-called “hot-money’s” appetite for the carry trade and may increase pressure not only on the Australian and New Zealand dollars (beneficiaries of the carry trade), but emerging markets in general.

The ample global liquidity conditions and favorable world growth dynamics may continue to underpin emerging markets in general over the next several months. Given the record low EMBI+ spread over Treasuries (around 165 bp), it is difficult to envision strong out-performance going forward. This appears to have encouraged interest in taking on local currency risk, especially in Latin America. Although yields are lower in Asia, the prospect for currency appreciation is greater than in Latin America.

Brazil’s central bank, which has been intervening daily for more than six months, has stepped up its operations. The Mexican peso/dollar rate (MXN/USD) appears comfortable in its broad trading range between 10.85-11.10.

There are two sources of broad upward pressure on Asian currencies. The first is coming from foreign inflows into the equity market. Foreign inflows into the Philippines, have been particularly strong at the start of the year, but the decline in the pace of flows into Taiwan’s shares should not obscure the fact that in the first six weeks of the year, foreign demand for Taiwanese equities ($1.4 billion) was equal to the combined inflows into South Korea, the Philippines and Indonesia. Add India and Thailand, and you can account for more than $3.3 billion of foreign demand. The average of a little more than $500 million a week is off last year’s record pace to be sure, and although the data is hardly comprehensive, it still suggests a source of upward pressure on local currencies and speaks to the total return of either fixed income or equity investments in the region.

The second force that may also encourage regional currency appreciation is China. Although still too slow for its critics, the pace of yuan appreciation has accelerated.

U.S. dollar movement Length of time
CNY8.10-CNY8.00 10 months
CNY8.00-CNY7.90 4 months
CNY7.90-CNY7.80 3 months

This suggests about a five-percent annualized appreciation of the yuan against the dollar in 2007. This is a little less than currently discounted by the non-deliverable forward market, which makes sense insofar as Chinese officials are loath for speculators to profit from the adjustment process. There are several regional currencies that have a good probability of out-performing the yuan in the coming months. These include the Thai baht, Philippines peso, Malaysian ringgit, and Singapore dollar.

While the favorable investment climate and weak U.S. dollar undercurrent may lend support to east and central European currencies, the medium term view is not as constructive. Macro-economic variables are out of balance and, without the discipline imposed by the drive to join EU or of trying to enter the eurozone as early as previously anticipated; the sense of urgency for reforms has slackened. Rate convergence has already largely taken place, and a number of fund managers have added the Czech koruna to the basket of financing currencies.