NOURIEL ROUBINI: CURRENCY DYNAMCIS

Altamente recomendable, gonzalo
The Peruvian sol (PEN) has been quite stable, trading at an average rate of 3.04 per USD over the past month; during the recent wave of financial turmoil it has also experienced the lowest volatility amongst peer-group floating currencies within Latin America. The central bank will continue to heavily intervene in the foreign currency market if need be. The USD/PEN is expected to close this year at 3.00.

RGE Monitor Logo
RGE Monitor's Newsletter

Greetings from RGE Monitor!



In today’s newsletter we focus on currency dynamics around the globe.



Does the U.S. dollar’s December slide mean the USD has passed its peak? Most likely not. The turn-of-the-year profit-taking on long USD positions creates a near-term blip in the dollar's uptrend but doesn't alter the medium-term trend of appreciation versus the euro. The four horseman of the carry trade apocalypse - Deleveraging, Risk Aversion, Growth Differentials and the Dollar's Reserve Currency Status - would need to retreat before we see a sustained pullback in the EUR/USD from the slide to near-parity ($1.10-$1.30). Governments, banks and other firms are still scrambling for dollars to repay their USD-denominated debt while signs of global recession and credit crisis spur on the flight-to-safety in U.S. Treasuries. European sovereign bonds offer an alternative but inferior safe haven because of the European bond market’s fragmentation and exposure to emerging Europe. More aggressive policy response in the U.S. compared to Europe, could bring the U.S. out of a recession faster than the Eurozone (though growth will most likely remain subdued for some years to come), supporting the dollar against the euro. In the longer term, however, once risk appetite revives, the greenback might lose its defenses in wake of worries surrounding U.S. public debt expansion and the potential inflationary effect of quantitative easing.



The Japanese yen hit a 13-year high against the dollar in mid-December when it broke below 90 per dollar. It may hold the distinction of being the only currency apart from the Swiss Franc that could appreciate against the dollar in early 2009 due to carry trade unwinding and repatriation of Japanese funds invested overseas. The recent surge in the yen is being driven by carry trade unwinding as well as a substantial shrinkage in US-Japan rate differentials. While there is room for the JPY to strengthen in the short-term, Japan’s increasingly gloomy macroeconomic outlook raises questions about its continued strengthening over the medium-to-long term.



The rest of Asian and the Pacific currencies are losing ground against the dollar. Faced with slowing growth and exports as well as withdrawal of foreign capital, many Asian currencies have fallen against the dollar, with those with current account deficits like South Korea and India hardest hit. Despite central bank intervention, the currencies of India, S. Korea, Thailand, Philippines, Indonesia have depreciated recently as global risk aversion contributed to outflows from EMs.



Declines of around 20% for these currencies may have contributed to some slackening by Asia’s other strong currency, the Chinese yuan. After appreciating against the dollar at the beginning of 2008, and tracking it closely through spring, summer and most of the fall, the yuan is now depreciating slightly against the dollar as Chinese growth slows and the Chinese try to temper the 25% appreciation against the Euro since mid 2008. Last weekend’s powwow between China, Japan and Korea which followed the Japanese and Chinese extension of credit lines to support the Won, may be the first step in greater exchange rate coordination within Asia and may help to support some faltering Asian currencies at least in the short-term. Meanwhile the dollar’s rally is putting the Hong Kong dollar under pressure when Hong Kong is in recession, despite the strong support for its peg from authorities.



The Korean won has been victim of the selloff of emerging market assets in an environment of acute risk aversion. South Korea gives the world an example of a net creditor in a currency crisis. The won’s downfall also has its roots in Korea’s high ratio of short-term external debt to foreign reserves (60% at end-2007). After international capital markets essentially shut down, Korean banks and firms have sought dollars to repay their external debt or sell off assets to do so – raising demand for USD versus KRW. This deleveraging, plus the export slowdown and portfolio outflows from Korean equity and debt markets, might keep the won weakening versus the USD until late 2009. The current account will likely improve if commodity prices remain low and import demand falls, but capital outflows will outweigh the effect of the current account surplus on the won.



Free floating commodity currencies like the Australian, Canadian and New Zealand dollars and the Norwegian Krone have followed their commodity exports values down - together the fall in commodity prices and currency corrections of 20-30% have eroded their terms of trade. Despite the chance that they may already have overcorrected, with further rate cuts to come, these currencies could slide further. And so might the South African rand, especially now that the Reserve Bank has joined the cutting cycle. But these currencies might not gain much from any prolonged dollar weakness unless commodities pick up much steam as all of these economies are facing sharp slowdowns at best and recessions at worst.



Other fuel exporters like Russia and Nigeria were reluctant to let their currencies slide and in Russia’s case spent significant portions of their ample reserves to avert it. But with Russia’s current account about to shift to deficit as early as this quarter and its reserves falling by almost 30%, it is now allowing more frequent 1% devaluations. The rouble may fall another 20% at current price points through Q109, meaning that Russia’s fx-denominated debt may become an even greater burden for the government especially as the devaluation expectation is contributing to retail and corporate deposit withdrawals from the banks – expect to see more declines in fx reserves. Nigeria too is allowing the Naira to shift downwards and the Kazakh Tenge may not be far behind. Meanwhile the dollar peggers among the oil exporters, especially the GCC, are no longer facing the appreciation pressure they suffered earlier this year even as the dollar’s rally has increased their purchasing power. In all of these countries, inflation is slowly coming down, even if it remains stubbornly in the double digits and weakening local currencies offset falling global price declines.



Most MENA currencies are pegged either to the dollar or to a basket which includes exposure to the euro - these pegs are expected to remain in place. However, the region's more flexible currencies have been allowing more depreciation. Egypt's pound plunged from a five-year high of LE 5.31 per USD in August 08 to a rate of almost LE 5.53 in December 08 and may continue depreciating in 2009 as Egyptian – and global growth – slows and Egypt's balance of payments continues to be weak. With inflationary pressures easing, the Central bank of Egypt (CBE) may do little to prevent the pound’s depreciation in hopes of boosting growth via cheaper exports, increasing tourism and Suez Canal revenues and attracting more FDI. Israel's monetary easing comes as the country is witnessing a significant growth slowdown - another rate cut on December 29 may further weaken the shekel. With many of Israel's export partners faltering, a weaker shekel has been 'desired' by the BOI for some time. However, government support of the financial sector may cause intermittent strengthening of the shekel.



Eastern European currencies are coming under pressure, in part due to spill-over from global market turmoil and in part due to domestic fundamentals. Many analysts are bearish on all CEE currencies given these economies’ heavy dependence on capital inflows. Nevertheless, some economies (i.e. Czech Republic and Poland) seem better placed than others (i.e. Hungary and Romania) and this should feed through to their currencies. Similarly, despite steep devaluation on the Ukrainian Hryvnia, pressure continues given its large current account and reliance on steel exports.



Devaluations in the works in the Baltics? The currency pegs in the Baltic economies, particularly Latvia’s, have been coming under pressure recently. Given their large external imbalances and the global financial crisis, the question has arisen as to whether these countries will be forced to give up their currency pegs to the euro. Many analysts, however, see no appetite for a devaluation as the high degree of foreign currency borrowing in these countries mean a devaluation could undermine financial stability. Moreover, the possibility of a speculative attack is limited by the shallow financial markets in the region.



The Turkish lira is among most risk-sensitive of EM currencies. The TRY shows a strong correlation to carry trade baskets given Turkey’s high interest rates and is therefore sensitive to unwinding. In the near-term, expectations of an IMF deal, as well as global risk appetite and monetary policy moves, are the factors determining the currency’s path. Analysts expect the lira to depreciate further in next 6 to 12 months given Turkey's large current-account deficit, increased global risk aversion, and sluggish foreign direct investment (FDI) inflows since beginning of the year.



Moving to Northern Europe, economic recession, vulnerability of Swedish banks (due to their exposure to sharply slowing Baltic economies) and the rate cycle have been weighing on the SEK, which hit record lows against the euro in December. Yet, a number of analysts now see the SEK strengthening over the next 12 months from its current levels.



In Latin America, the Brazilian Real (BRL) remains a source of concern on the inflation front, continuing to show a weakening bias after having depreciated over 30% in the last three months. While Brazil’s external indicators suggest the currency is overshooting, the authorities cannot ignore its persistent weakening. Estimates of the historical pass-through from BRL movements to domestic consumer prices stand at around 8-10% after approximately one year.



The Mexican peso (MXN) seems to be stabilizing after a volatile adjustment phase that affected energy-linked emerging-market economies. Interest rate differentials, banking sector systemic health, a swift government response to the global financial crisis, still large central bank FX reserves, and the reciprocal currency arrangement between the US and Mexican central banks have been MXN-supportive.



The Chilean peso (CLP) has discounted a sharp contraction in trade-linked currency flows, despite a relatively solid fiscal position. Interest rate differentials are not a CLP supporting factor in spite of the fact that the central bank has earmarked the fight against inflation as a key priority. The sharp commodity price adjustment anticipates a weakening prospect for Chile’s export sector.



The Peruvian sol (PEN) has been quite stable, trading at an average rate of 3.04 per USD over the past month; during the recent wave of financial turmoil it has also experienced the lowest volatility amongst peer-group floating currencies within Latin America. The central bank will continue to heavily intervene in the foreign currency market if need be. The USD/PEN is expected to close this year at 3.00.



In Venezuela, the government has stashed away substantial funds during the windfall oil years. With prices falling bellow USD60pb and local inflation rampant the government fiscal accounts remain vulnerable. This will lead the government to devalue the VEF currency sharply in Q1, likely by 30%.



In Argentina, the central bank is letting the peso devalue in a gradual and controlled manner. The central bank is managing the slide in an effort to avoid further eroding investor confidence in the peso.