Emerging Markets FX - Inflation an EM buy signal:: HSBC

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Emerging Markets FX
Inflation an EM buy signal


 After the FOMC, rising inflation concerns could provide the
next boost for emerging market currencies
 We are some way from the point where inflation might be
currency negative
 Currencies likely to benefit include: INR, MYR, SGD, MXN,
CLP, and PLN




With the FOMC meeting finally behind us, and USD-EM declining as a consequence, we
can now turn to focusing on a less singular range of currency drivers. On this front, much
talked about and so far unseen, we might now be on the cusp of inflation becoming a more
important dynamic for EM currencies. All of a sudden, it seems, upstream inflation
indicators are accelerating quickly. Consider that the CRB has risen to its highest levels
this cycle, the UN Food and Agriculture Organisation this week warned that food prices
were back to levels seen during the early stages of the 2007 food crisis, and the latest
round of Asian PMIs show rising output prices (see Does the world really need QE2?
What the latest PMIs mean for Asia, 2 November 2010, by Frederic Neumann). The rise
in the CRB during the pre-FOMC period was particularly significant, we feel, given many
other financial markets held to existing ranges.

A near-term boost
As the dust from the FOMC settles, and the market moves on to thinking about other
things, price pressures are likely to become a key part of the near-term dynamic that
delivers stronger EM currencies, in our view:
 An increased inflation focus will likely contribute to an upgrade of currency markets’
perceptions of future rate hikes in EM. Poland and Korea are likely to be near-term
movers on this front, according to our economists. In fact, it’s worth remembering
that over the past month, as the Fed and BOJ have eased, we have seen tightening in
Australia, China, India, and Singapore.


 It will also highlight the inconsistency between the global rhetoric on currency policy and domestic
monetary policy across many EM countries. In HSBC’s recent piece on capital controls (see Manning
the Barricades: The return of capital controls and the implications for global markets, 2 November),
we argued that despite the increased global focus on capital controls, the framework for EM currency
investors had not really changed. The vast majority of countries will likely seek to (continue to)
moderate the pace of currency appreciation, rather than reverse or prevent it altogether. A gradual and
evolutionary approach to currency management is more likely than a revolutionary one.
 Rising price indicators may also change perceptions about the strength of the global economy, and
hence assuage concerns about a double-dip, at least for now. See our mention further on of the latest
developments in some leading indicators.

But what about 2008?
During 2007-08, as inflation indicators rose, inflation became a progressively more negative influence on
EM currencies. While a repeat of this state of affairs may present a risk down the track, we are still some
way from this situation, in our view. Of the three EM areas, Asia is the region most likely to give early
warnings of such a shift. After all, Asia is where discussion about potential asset bubbles and excessive
credit creation is most active. In EMEA most economies are growing below trend, while in Latam we
perceive central banks to have any inflation risks well in hand. Also, Latam’s issues in 2007-08 related to
high energy prices more directly – the rise in oil
prices has been orderly thus far. Even for Asia,
however, there are several reasons to think that
there is little negative risk from inflation for

Asian currencies in the near term.
 Rates of inflation, both commodity and
consumer, are simply much lower at present
than in 2007-08 (see Charts 1 and 2). As a
consequence, even though interest rates are
lower, real interest rates in most countries are
not that low.


 External balances are in much better shape this time. In 2008 the region (excluding China and India)
saw its trade surplus disappear as domestic booms, coupled with sharply higher commodity prices,
offset the effects of an ongoing export boom. Currently, the regional trade surplus is near cyclical highs.
 Lastly, regional fiscal policy is not under the pressure it was in 2008. While regional deficits are not
exactly low, they are off the radar because a number of G10 countries’ deficits have reached
stratospheric levels. It also reflects (a) the fact oil prices are not rising as strongly as some other
prices (see the commentary from Frederic Neumann, It feels like 2007, 25 October); and (b) energy
subsidy regimes are less generous in many countries (China, India, Indonesia, and Malaysia
particularly) than they were in 2008.

Risk of double-dip to diminish?
As the inflation dynamic potentially rises as a market driver, fears of a double-dip may well
correspondingly diminish. While flows into EM have been strong, they may well have been stronger if
investors had been more confident about the near-term path of the global economy. Concern about weak
global activity driving a flight out of EM has certainly been a well-cited concern over recent months. A
perusal of recent leading indicators, however, supports the view of our economists that ongoing
stagnation in the HIICs is more likely, rather than a further sharp slowdown from current growth rates. In

Charts 4 to 7 we present leading indictors from both the OECD and national agencies, for the G7,
Mexico, Taiwan and China. The OECD-sourced indicators are particularly interesting. These tend to be
very smooth, suggesting that early indications of a turn are typically sustained for a while. All in all,
another line of argument suggesting that flows into EM will persist in the near term.


Conclusion
With currency policy becoming an increasing influence on currencies, our favoured ways to play this
inflation dynamic at present are:
 Asia: INR, MYR and SGD are favoured. Although PHP is still one of our favoured currencies, the
collapse in the forward points makes this an untenable position in the short term, even though
unsterilised intervention strengthens the medium-term case for PHP appreciation.
 Latam: MXN and CLP are preferred. There is greater official resistance for BRL and COP, although
they should continue to appreciate medium term.
 EMEA: PLN is favoured as the NBP is likely to be the first rate hiker in the region, and official
resistance is less than the other yielders in the region (ZAR and TRY).