EMERGING MARKETS
liquidity in EM currency and equity markets. Notably absent from this explanation of EM FX contagion is the cause cited by many market analysts, namely that the Fed tapering of QE was mostly to blame for creating an EM risk-off market environment. Second, although commentators frequently
characterize this episode as “EM sector contagion,” in fact there were large and striking differences in FX and equity market performances among EM countries. The most volatile currencies were those for which home-country political risk raised its head, such as the Argentine peso and Turkish lira. Moreover, countries with relatively stringent currency controls were not immune. The Indian rupee depreciated sharply while China shifted to being a net seller of US Treasuries to keep its currency in the desired range in the face of implied downward market pressures. Third, following any storm in the markets, two
competing scenarios for the future typically emerge: (a) the storm will abate and leave selected buying opportunities in its wake, or
(b) the storm will intensify, with yet further FX and equity depreciation.
For the present, in our view, the probabilities of the
storm abating have the upper hand. This is because more robust growth in the US, and even some modest economic improvement in Europe, will provide a solid foundation for global trade flows on which EM FX can stabilize. From a political perspective, however, we see a continuation of relatively high risks in many countries. This leads us to expect potentially wide divergence in FX and equity market performance among EM countries in 2014, depending on the evolution of local political risks. Fourth, and encouraging for the more optimistic
scenario, is the continuing development of more EM currency trading activity in London, on CME Group global electronic platforms, and in regional off-shore centres and exchanges. Moreover, there is more trading activity even in the NDF currencies where there are exchange rate controls and other capital flow restrictions for domestic purposes. More active currency trading is a sign of incremental improvements in global economic integration, and it means that markets are developing to provide needed liquidity. This trend helps establish stronger linkages such that EM countries can benefit more quickly from any improvement in economic conditions in the mature industrial world. Moreover, because of contagion episodes, there are
EM countries and central banks that often feel that their currencies are victims of the speculative element in the markets. We take a different view that is heavily influenced by the degree of liquidity available in a currency. Where liquidity is lacking, global asset allocation shifts are likely to be more violent and
Figure 4: Chinese Holdings of US Treasuries $1,500
$1,000 $500
Currency Challenges Are Reflected in More VolaAle US Treasury AccumulaAon
$0 2001 2003 2005 Source: Bloomberg Professional
feed contagion. Where liquidity is seen as relatively good and trading activity is more active, contagion is less likely. There is a parallel with capital controls and flows. Countries that restrict capital flows make it hard to take money out so foreign investors are circumspect about investing – putting capital into the country. By contrast, countries that allow a freer flow of capital and currency movements actually have a
From a political perspective, however, we see a continuation of relatively high risks in many countries
relative advantage in attracting capital. Put another way, if one tells me I can take money out, I will put it in, and if one tells me I cannot take money out, I will not put it in. Thus, improvements in liquidity and trading activity
have the potential to allow for country differences to shine through and to reduce the probabilities of future contagion. There are encouraging signs that even amidst the current contagion liquidity is likely to improve over the next few years, making future contagion less likely or possibly less severe. •
Blu Putnam is Chief Economist & Samantha Azzarello, Economist, CME Group.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions.
This report and the information herein should not be considered investment advice or the results of actual market experience. To read more of our Market Insights, visit
cmegroup.com/marketinsights Copyright © 2014 CME Group.
All rights reserved.
www.cmegroup.com March 2014 71 2007 2009 2011 2013
Billions of US Dollars
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