- All currencies are not the same; emerging market FX trades differently than developed market FX.
- Key differences between DM FX and EM FX are the enforcement of private property rights and the independence of monetary policy.
- Traders should watch rates of inflation, bond spreads, and export growth (among others) as they gauge whether or not crises are developing in emerging markets.
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Not all currencies are created equally. Given the nature of different economic systems and circumstances, the factors that motivate developed market currencies (“DM FX”) like the Euro or the US Dollar are different than the factors that motivate emerging market currencies (“EM FX”) like the Argentinian Peso or the South African Rand.
It’s often the case that traders’ attention turns to EM FX ex-post facto. That is, it’s fairly typical for the average trader to only be made aware of the fact that an emerging market currency has made a big move only after the move has occurred. This leads to the undesirable behavior of “chasing trades,” or for lack of a better term, “FOMO” – the “fear of missing out” on a trade provokes a trader into taking positions that don’t necessarily fit with their strategies.
How are Developed and Emerging Markets Different?
Before we look at the seven key factors that traders should monitor before a crisis hits emerging markets, it’s important to recognize key structural differences between EM FX and DM FX economies.
Developed Market FX:
- More established financial institutions
- Robust legal infrastructure
- Strong enforcement of private property rights
- Control over own fiscal policy and own monetary policy
- Monetary policy independent of politics
Examples: US, UK, France, Germany, Japan
Emerging Market FX:
- Less established financial institutions
- Less developed legal infrastructure
- Weak enforcement of private property rights
- Might not have full control over fiscal policy and monetary policy
- Monetary policy not independent of politics
Examples: Argentina, China, South Africa, Turkey
As a result, crises take different forms in developed market economies and emerging market economies. Issues in developed market economies are typically seen in one area: the labor market (unemployment rate). But because emerging market economies don’t have fully-formed labor markets and may not have complete access to the global economic system, traders need to keep an eye on other metrics to spot crises as they developed.
These are the key seven factors traders should watch so they may spot a crisis coming in advance - and in turn, not find themselves chasing a move.
1. External Financing: Current Account
The Current Account is one of two parts of the Balance of Payments (the other being the Capital Account). The Current Account is comprised of net-cash transfers, net-income, and the balance of trade. When an emerging market economy runs a Current Account Surplus (good), it means that they are producing more than they are consuming. A shrinking Current Account Surplus or a growing Current Account deficit are undesirable (bad).
2. External Financing: Foreign Direct Investment (FDI)
Foreign Direct Investment is more than just a capital investment; it involves hiring and training of employees as well as establishing significant business operations in another country. To this end, when an emerging market economy experiences FDI inflows, it is seen as a sign of foreigners’ optimism in longer-term growth prospects (good). When an emerging market economy experiences FDI outflows, particularly acute outflows, it can be seen as a sign of deteriorating long-term growth prospects (bad).
3. Export Growth
Most emerging market economies are industrial or manufacturing based, and therefore, they rely on foreigners purchasing their goods. Growing Export Growth is a positive sign; shrinking or contracting Export Growth is a negative sign.
4. External Debt-to-GDP
Emerging market economies typically don’t have established capital markets. As a result, investors and governments will need to look abroad to fully finance their projects. Country’s that run large External Debt-to-GDP ratios are vulnerable when market conditions become turbulent; investors like to keep their capital closer to home. An emerging market economy with a large External Debt-to-GDP ratio is vulnerable to foreign creditors imposing politically unsaleable conditions that lead to wider spread instability.
5. Implied FX Volatility (1-month)
Like their developed market counterparts, EM FX with higher rates of implied volatility tend to do worse than those currencies with lower implied volatility. Rising implied volatility, particularly at the overnight, 1-week, 2-week, and 1-month tenors, indicates rising risk in the immediate term.
6. Bond Risk Premia
Bond spreads are used as way to gauge the level of risk in one debt security relative to another. Typically, investors measure the difference between the US Treasury 10-year yield and other bonds to determine their Bond Risk Premia, or the excess yield required in order to justify the additional risk in investing in something other than the ‘risk free asset.’ While EM FX will see their currencies
Many emerging market economies do not have full control over both their fiscal and monetary policies. Some countries’ governments peg their currencies to another (exporting monetary policy), while others remove the barriers between politics and central banking (eliminating independence). As a result, policy responses may not be coordinated in an efficient manner. Due to the lack of proper countercyclical policy processes, evidence that Inflation rates are increasing in emerging markets is often a sign that policymakers will be unable to keep the value of their currency stable.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
To contact Christopher Vecchio, e-mail at email@example.com
Follow him on Twitter at @CVecchioFX
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