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Weakened EM currencies hurting returns, BRICs likely to face devaluation soon

MSCI Emerging Markets vs DBEM 2013-04-05Enlarge Graph

Several emerging market currencies have depreciated year-to-date, hurting the overall emerging markets returns. Currency depreciation is affecting market returns; MSCI is down 2% year-to-date.

Most notably, the equity markets in Eastern Europe have dropped significantly given their proximity and dependence on the western European countries. The Czech, Polish, and Hungarian MSCI Indices are down for the year by 14.1%, 11.5% and 6.6%, respectively. The foreign exchange losses have been 5.3%, 4.8% and 7.1%, respectively. The Hungarian Stock Market has been almost flat for the year, but the foreign exchange loss has killed its return in U.S. Dollars.

Outside of Europe, South Africa has also received a foreign exchange beating that amplified its marginally negative losses to close to 10% when factoring in foreign exchange depreciation versus the U.S. Dollar.

Additionally, many Asian countries (excluding China and Japan) have been hurt by the severe depreciation of the Japanese Yen, which depreciated 8% year-to-date and has given Japanese exporters a huge price advantage versus other companies in the region. For an example read this article on the Thai Baht appreciation.

BRICs ripe for devaluation wave

Most of the BRICs, with the exception of China, are facing significant inflation pressures and have been avoiding increasing interest rates to maintain their meager economic growth.

Brazil: Kept interest rates unchanged despite inflation getting close to the target 6.5%. The government has implemented an aggressive energy subsidy to control inflation. Year-to-date, the Brazilian Real appreciated 1.8%.

Russia: Kept interest rates unchanged despite high inflation and further inflationary pressures coming in Q3. Year-to-date, the Russian Ruble has depreciated 1.8% already.

India: Cut its interest rates and chose to ignore the fact that current inflation of over 7% falls outside the 4-6% target limit. Year-to-date, the Indian Rupee appreciated 1.1%.

China: China is the only exception. Producer inflation is down and consumer inflation under control. Furthermore, the government has tight currency flow controls to contain the exchange rate versus the U.S. Dollar. For this reason, year-to-date, the Chinese Renminbi has appreciated just 0.2%.

Implications

The continued European crisis has strengthened the U.S. Dollar while at the same time emerging market exports to developed markets has weakened. As a result, emerging market currencies have depreciated versus the U.S. Dollar and amplified losses in weak emerging markets.

The export advantages of currency depreciation in Asia have benefited mainly Japan and hurt the rest of the southeast Asian countries, hence their stock markets as well have suffered.

Brazil, Russia and India seem to be the next targets for devaluation given their inflationary pressures and unimpressive growth. Their large share of popular emerging market ETFs (e.g. EEM, VWO) would severely affect returns should their currencies depreciate significantly. While a weaker currency could boost exports, global trade remains weak due to the poor economic condition of developed countries.

In the short to medium term, emerging market investors should ideally hedge against currency fluctuations. There are some ETFs that offer hedged market indices, such DBEM, which offers a currency hedged version of the MSCI Emerging Markets Index (the same followed by EEM). An option for Brazil only is DBBR, which tracks the MSCI Brazil Index (the same followed by EWZ). It is important to keep in mind, though, that the hedges represent additional costs and will not completely offset currency movements and will also limit gains from currency appreciation.