This is Part IV of an ongoing series on how to trade emerging markets.
Emerging markets are of increasing interest to many traders and investors. Interest rates in developed markets are at zero (or in some cases below zero) with the yield on longer-duration, riskier assets heading down toward those yields as well.
Nominal yields in emerging markets are still positive, with healthy 1.5-5 percent yields on cash in most EM economies. Those above 5 percent cash yields tend to have high political and economic risk (even by emerging markets standards) and are often relatively early in their stages of development.
In Part I, we covered the early part of the cycle in emerging market economies.
In Part II, we covered the up-cycle leading to the “bubble” phase, and the lead-up to the consequent top in the market.
In Part III, we covered the market top, beginning of the reversal, and initial defense of the currency.
Part IV will delve into the next part of the cycle past the top, which results in a contraction of its economy and markets. This is typically, but not always, marked by monetary authorities letting the currency fall.
As mentioned in the previous section, a country often faces economic problems for reasons that are analogous to that of an individual or family.
Every individual or household, corporation, and country has a certain amount of revenue, a certain amount of expenses, and a balance sheet displaying assets and savings relative to liabilities (mostly debts).
A drop is usually set off due to a loss of income, an increase in costs, a tightening in credit, or from the burden of large borrowing that becomes difficult to service.
If one or more of these events is triggered it could lead to a deficit where revenue is too low relative to expenses. There’s a certain amount of savings that can be tapped into, and the rest has to be filled or rectified another way (e.g., debt issuance, cutting costs).
A country, however, has a big advantage over an individual or corporation. Given a country can create its own money, it can change the amount of money in circulation.
This, of course, is not “free” because the act of producing more of something changes its value (down), holding all else constant.
This is nonetheless an important way that countries can manage their balance of payments issues. It’s also why we have many different currencies instead of a single international currency – it allows countries to alter the supply of money in light of their own conditions. One country’s monetary policy will not be appropriate for another.
When the value of a currency is changed, this changes the price of goods and services for domestic citizens more than it does for foreigners.
To illustrate, let’s say for an individual his salary is cut by 50 percent. This is likely to have a big adverse economic effect.
However, if a country were to devalue its currency by 50 percent, that 50 percent “pay cut” is only relative to the rest of the world. And it has some positive stimulatory effects such as making exports a lot cheaper, thus making them more affordable to foreign buyers. The wages of domestic citizens still stay the same.
The country can therefore help take in more business from abroad without having to take the deflationary effects internally. The deflation is, in a sense, exported.
Letting the currency fall
Because of this ability, monetary policymakers, after a point, typically choose to stop supporting the currency in ways that aren’t sustainable.
Currency support measures generally include:
– tightening monetary policy by offering a higher rate on the currency (cuts credit creation and drives down economic activity even further)
– using FX reserves to buy their own currency (they will often use 10 to 20 percent of total reserves, and reluctant to go further)
– “jawboning” their domestic currency market by asserting that they’ll prevent it from being devalued
– occasionally capital controls are put in place (though difficult to pull off because people get around them and the notion that they could be implemented is enough to set off a desire to get capital out of the country)
Because these options aren’t particularly attractive, policymakers will usually recognize the fundamentals aren’t worth fighting against and let the currency depreciate. Sometimes they don’t let it fall at once and manage its decline downward.
After the currency is let go:
– there is a big initial depreciation, often by 30 percent or more
– the losses suffered by holders of the currency are severe, as the decline is not offset by the interest rate provided on it
– because of the steep drop, monetary authorities will usually try to smooth out the loss, and this causes them to use reserves until the currency finally reaches a two-way market where the supply and demand for the currency is in equilibrium
The benefits of a currency devaluation
A currency is not worth defending when interest rates are too high relative to the nominal growth rate of the economy, or when foreign exchange reserves (i.e., a form of national savings) are spent to a dangerously low level.
The dangers of each is worse than the adverse effects of a devaluation.
The devaluation also comes with the benefit of being stimulative to the economy.
Foreign debtors, in particular, can repay debt more easily when the currency declines. A 50 percent devaluation is like cutting principal and interest payments in half.
And as mentioned, other countries can purchase more goods when they’re effectively getting a big discount. This can help bring in more revenue from overseas at higher margins and better line up national income relative to spending.
Imports become more expensive. Domestic producers benefit with less competition from foreign goods.
Because the currency declines, this makes assets in that currency more attractive to purchase, which can also bring in foreign buyers whose money goes further.
The drawbacks of a devaluation
Currency devaluations of course come with drawbacks.
How they’re managed and the nature of the fall influences the degree to which the economy is impacted.
How fast and how far the currency declines affects the trend in inflation and its level.
When emerging markets have debt busts and downturns in their economies, these are usually inflationary, the dynamic of which is led through the currency.
Currency weakness creates higher prices for imported goods. Most of this is passed through to consumers, creating a rise in inflation.
If the decline in the currency’s spot rate is managed in a gradual, persistent way, the market will anticipate additional currency depreciation.
This often encourages more speculation in the currency (i.e., high short positioning) and increased withdrawals of capital from the country. This increases the balance of payments deficit.
Inflation psychology is also a real phenomenon and accompanies a devaluation. To “get ahead of inflation” people will often take their paychecks and/or borrow money (if it’s cheap enough relative to the rate of inflation) to buy things before they go up in price.
This feeds inflation further. It is typical for inflation to get up to 30 percent or more at the peak when measured on an annualized basis, average in the 10-20 percent range, and last at this elevated level for 1-3 years past the top in the market.
If it goes too far, this can cause the currency to cease becoming an acceptable store of wealth. For emerging market countries, this is already an issue without much demand for the currency and their debt globally.
For these reasons, it is generally better to have a devaluation that gets the market back into a two-way equilibrium right away.
It means higher inflation is likely to last longer. But it comes with the benefit of not needing to expend reserves or raise interest rates to manage the devaluation. Due to the desire to not have to expend reserves or raise interest rates (and worsen economic weakness), policymakers will generally bluff and say they’ll defend the currency right up until they cease doing so.
Who gets hit by the devaluation
Savers (e.g., holding cash and bonds) get hurt by the devaluation, as the value of their money just went down. This is especially true for foreign entities holding that currency.
Because of the large move, this sparks fears of additional devaluation. It can carry the currency down further even if policymakers create a genuine two-way market by letting it fall down to a new equilibrium without interference (e.g., no expenditure of reserves, no increase in interest rates).
Moreover, some participants in the market can create additional selling pressure if they’re forced to unwind asset-liability mismatches.
For example, some foreign investors may invest in the country’s markets by holding local-currency assets while borrowing in their own currency. If the currency falls, they may be underwater on their investment (and may be leveraged), forcing them to unwind or they may believe the new set of conditions makes the investment unprofitable.
Selling out of these assets and withdrawing their capital from the country makes the currency fall in a self-perpetuating way. Foreign lenders and investors become less willing to lend and invest capital in the country. Capital outflows typically proceed at a pace of 3 to 5 percent per year.
Capital being withdrawn from the country has an impact on spending. The spending of one entity is the income of another. When spending slows, this is also self-sustaining, as incomes decline. This causes a further decrease to spending, and so on. Job losses stack up and growth declines.
Domestic banks and lenders of all forms will have debt problems.
Those who earn incomes in local currency and have liabilities in foreign currency will see their debt payments go up a lot. For example, a 50 percent drop in the currency is effectively like a doubling in interest and principal payments.
The rise in debt servicing creates a squeeze that hits incomes and spending further.
Money printing is conspicuously low
Unlike developed markets, which have reserve currencies (at least to some extent) and can create money to fill the gap (e.g., the response to the 2008 financial crisis and 2020 coronavirus pandemic), emerging markets have limited power in this sense.
There is limited global savings in their currency, which means there is limited demand for their debt. The central bank printing money risks more people expecting further depreciation in the currency and wanting to get their money out.
Accordingly, there is typically limited money printing to fill in the balance of payments gap. Policymakers may try it because it’s an alluring option, but usually on the order of just 0 to 2 percent of GDP.
The lower growth rates are going to cause many lenders and investors to withdraw their money from the country regardless. In very little time, the “hot” country to be bullish on sees its assets go from overbought to oversold.
Prices decline. In local currency terms, equities generally decrease around 50 percent. Because of the sell-off in the currency, the decline in equities is worse in foreign currency terms.
Holders of local currency that owe debts denominated in foreign currencies have limited ability to cope upon a devaluation outside of putting on hedges or moving more of their savings in foreign currencies or tangible (but ideally liquid) assets. This, however, exacerbates the decline.
Trader and investor psychology
The country goes from a great place to invest to being terrible.
Various types of problems emerge that are connected and reinforcing – debt, economic (weak growth, high inflation), currency, political, social, and so on.
Companies that engage in accounting fraud and other corrupt practices find their enterprises more difficult to sustain.
Foreign investors have qualms about entering even as assets cheapen and domestic investors want to get their money out of the country or into non-financial stores of wealth.
Peak pessimism is usually when the market bottoms out. It becomes the polar image of the top that characterized the peak optimism of the bubble.
In the case of the top, there’s a lot of capital chasing too few opportunities, bidding up prices beyond sustainable levels. At the bottom, the high volatility and cocktail of various problems turns off traders and investors who had considered entering the market. Risk premiums expand out to wide levels.
A lot of assets come up for sale and there are two few buyers. Holding the assets become very painful to those who own them. Investors who experience cash flow problems from having too much exposure to the market – usually due to a combination of leverage and the fall in assets and the currency – have to liquidate or pullback exposure even when they know it has nothing to do with the cheapening fundamentals.
What characterizes the bottom?
When the currency becomes cheap enough that improves the balance of payments. It’s easier to export goods when they’re cheap to international buyers. Imports also become very expensive, and are typically cut substantially.
The closing of the trade balance is usually enough to get the balance of payments in line. The extent to which this is true depends on the degree to which trade is a part of their economy.
Argentina, for example, has a history of trade protectionism and the trade balance is a difficult way to rectify the balance of payments. This is why the country, which has these economic issues frequently, often has to turn to international aid to fix its economic problems.
This includes organizations like the International Monetary Fund (IMF), Bank for International Settlements (BIS), the World Bank and other multinational organizations to get the required funding to help turn its problems around.
Oftentimes, there are political changes around these down-cycles in democratic republics as the economic issues cost incumbents their leadership roles. Argentina’s economic difficulties under Peronism helped elect right-leaning capitalist Mauricio Macri in 2015.
Lingering problems the country’s ninth default in 2019 (in the run-up to the election) also cost him his presidency.
The more severe the economic problems, the more social conflict comes into play. This flows into political movements. Electoral outcomes have a wider-than-normal distribution on the left-right spectrum.
Populism has its own flavor on each side. Populists of the left (staunch socialists) and populists of the right (staunch capitalists) gain traction in their campaigns.
When the various economic, debt, currency, political, and other problems occur when one “side” is in charge, that increases the odds of electoral outcomes swinging the other way. Oscillations from one side to the other are common in democratic republics as memories of the problems of the other side fade and more people want change in leadership.
Politicians are also more short-term oriented. There is pressure to provide people want they want in the present without much thinking about where are all the money is going to come to pay for all the “stuff” and promises. Elected leaders want to spend a lot of borrowed money and promise a lot that creates a lot of debt and debt-like liabilities that will cause issues down the line.
In exchange for aid, the IMF, BIS, World Bank, or the organization providing aid will ask for policy adjustments to get the country on a more economically sound track and not repeat past mistakes.
This can include:
- Cutting inefficient spending and expenditures, balancing budgets or reducing fiscal deficits, reducing balance of payments gaps, and other austerity measures.
- Finding ways to enhance economic output. This can include encouraging resource extraction to build a larger export base or enhancing education to build a more robust services sector.
- Opening up trade through the removal of tariffs and other import and export restrictions.
- Decrease inefficiencies and waste via increased privatization of the economy through incentives (e.g., lower business taxes, lower regulations) and divestment of state-owned enterprises.
- Enhancement of private property rights.
- Improve governance procedures to crackdown on corruption.
- Build or better open up domestic capital markets to assist in foreign direct investment (FDI) inflows; improve investor rights.
- Remove wage controls and/or price controls that create distortions and supply-demand imbalances.
- Suggestions to improve currency policy (e.g., devaluation is stimulative, though can exacerbate debt problems in countries with a high amount of foreign exchange debt).
- Suggestions to monetary policy depending on expected growth and inflation trends, as well as the country’s individual financial stability situation.
During this phase, the drop in output relative to potential typically lasts 3 to 6 years.
Part IV covered the fall in the economy and markets and what characterizes the bottom.
The transition from the top in the local markets to weakness is marked by worsening fundamentals. Debt builds, the balance of payments worsens, and usually a shock is set off that reduces incomes relative to debts, or increases debts relative to incomes.
Policymakers generally prefer to let the currency go after a point, which is superior to other often unacceptable alternatives like using FX reserves or increasing interest rates. A weak currency is also stimulative to exports and help rectify the balance of payments imbalance.
Greater ease of exporting is great for manufacturers, boosts margins, and is stimulative to the stock market, holding all else equal. Foreign debtors also receive relief as their liabilities are not as burdensome with the depreciation.
A depreciation also keeps wages the same in local currency terms, but generally produces inflation. Imports cost more, which is usually passed off to consumers.
Savers are worse off, as is practically anyone holding the currency and debt. More people look to move their money into other currencies and tangible assets. Policymakers typically don’t print money to relieve the balance of payments gap, as this typically increases the desire to move money offshore.
Capital controls – and more rarely, price and wage controls – are sometimes implemented, which also normally exacerbates the desire to move money out of the country.
Countries will see the fall in economic activity bottom when the balance of payments gap closes (the fall in the currency makes exports cheaper to foreigners and imports are more expensive). Sometimes they will require help from international organizations for lending support. These organizations will typically offer aid in exchange for improvements to their monetary and fiscal policy mix.
Asset prices go from overvalued at the top to undervalued at the bottom. Equities typically lose about half their value in local currency terms and more in foreign currency terms due to the fall in the exchange rate.
Once the imbalances are rectified through the currency adjustment or external support aid, the country can work its way back to a normalization.
This will be the focus of the fifth and final installment of the series.
We will also look at characteristics of cycles that are managed well and those that are managed poorly.
When market participants watch these cycles occur in many different countries and understand how things are mechanically playing out, they can begin to understand what to watch for and how to trade them in real-time, much like how a mechanic can diagnose a problem with an engine or a doctor watching the progression of a disease.