Emerging markets and FX risk

Emerging market currencies overview

Figure 1 shows the MSCI Emerging Markets Currency (CCY) Index. This index tracks the performance of 25 emerging market currencies relative to USD and EUR. We observe that 2014 started off with a strengthening of the EUR and USD vis-à-vis the emerging market currencies. Emerging markets have experienced some downward pressure on their currencies as investors pulled back their money in anticipation of rising US interest rates.

Figure 1. MSCI Emering Markets CCY index

From the second quarter onwards, emerging market currencies appreciated against the USD and EUR again. Investors’ sentiment regarding interest expectations within Europe and the US, as well as the Fed’s monetary policy, changed. Halfway through the third quarter, the USD strengthened again, driven by a strong rebound of US growth in the second quarter and continued improvement in the US labor market combined with slower Chinese growth and lower commodity prices. In contrast to the US, European growth lagged behind resulting in a weak performance from the euro.

There has been real severe pressure on a limited number of countries, most notably Argentina (caused by high inflation, erratic government and the partial ‘technical’ default) and Turkey at the start of 2014 (caused by high inflation, gaping current account deficit and political upheaval). The figures below illustrate the impact on the EUR-TRY and USD-TRY as well as the extreme volatility of the TRY.  

Fig 2. TRY-USD and TRY-EUR 2014	Fig 3. Volatility USD-TRY and EUR-TRY 2014

Plunging oil prices in the last quarter of 2014 put strong pressure on the currencies of oil exporters. The RUB dropped dramatically (see figures 4 and 5) after the drop in oil prices, while other factors such as the Ukrainian conflict also played an important role in the depreciation of the RUB. Furthermore, political factors caused vicious volatility in various emerging markets as well. For example, the BRL has rallied by more than 12% after the country’s elections held on October 5th 2014.

Fig 4. RUB-USD and RUB-EUR 2014	Fig 5. Volatility RUB 2014

At the start of 2015, oil prices are halved compared to June 2014. It is expected that this will result in a positive net economic effect in many emerging markets as commodity exports are either non-existent or represent a small share of GDP for the majority of emerging markets (e.g., China, South Korea, Taiwan, Turkey). 

Managing the impact 

The macroeconomic changes and political factors directly impact the relative FX valuation and FX volatility. As a result, this affects profitability and means volatility for companies’ earnings. The increasing importance of the emerging markets, in combination with the higher FX volatility, makes companies doing business in emerging markets more exposed to these FX risks. Specifically, compared to maturer economies, there is additional complexity in terms of managing emerging market FX risks, with include factors such as:

• Restrictions and underdevelopment of the local financial markets
• The involvement of local joint venture partners
• Exchange controls
• The limitations to integrating emerging market operations in a standardized and centralized treasury (in-house banking) model.

The treasurer can reduce earnings volatility and protect value by identifying and quantifying FX risks and understanding the opportunities associated with doing business in the emerging markets. Relatively common hedging techniques may not always be suitable or possible in emerging markets due to factors such as a lack of liquidity in the local market, the fact that cost of hedging tends to be higher due to unfavorable interest differentials, significant bid-ask spreads and limitations in offshore hedging.

Fortunately, there are methods that treasury can employ to actively manage FX risk.

Treasury will have to deploy different strategies and instruments to manage the transaction and translation of FX risks in emerging markets, such as:

• Natural hedging of long-term translation FX risk (risk from the translation of net profit and net assets). This investment exposure can be managed by funding the emerging market operations with local currency debt rather than foreign currency equity or debt. The advantage is that unfavorable shocks do have a limited effect on the key ratios and consolidated financial statements and balance sheet of the firm.
• Non deliverable FX options and FX forwards, which can be traded offshore.
• FX options, especially low delta out-of-the-money options, can be seen as a means of protection against severe unfavorable market movements.
• Portfolio approach, such as basket options or proxy hedges.
• Basket options can be a cheap way of protecting against adverse currency moves on an overall basket-of-currencies basis.
• Proxy hedges: this approach includes identifying high correlations between currency pairs to find suitable proxy hedges to hedge the target currency with an effective hedge at a lower cost. The proxy currency can have higher liquidity, better (offshore) hedging possibilities or lower cost of hedging. The creation of a proxy hedge creates an additional risk in itself because of the risk that the bandwidth will be widened or the risk that the peg will be abolished.

In order to employ the above methods in line with best practice, it is important to quantify and monitor the emerging market risks associated with your business and currencies. Decisions on which methods are most appropriate should be based on current market information as well as on future expectations. An assessment will have to be made on whether the reduction in risk justifies the additional cost of hedging.

Due to market restrictions and hedging limitations, a perfect plain hedge will not always be possible, hence a proxy strategy or diversification strategy on the other hand may be effective as well because foreign exchange swings can potentially even out. This can be assessed with the help of a quantitative assessment.

After setting the methods of managing FX risk, it requires regular reviews since emerging markets are continuously changing. Setting corresponding key risk indicators (KRIs) and risk triggers plus implementing stress testing and scenario modeling are a vital way to monitor the FX risks and hence actively manage FX risk in emerging markets.

Overall, active management of emerging market FX risks will reduce the volatility in company earnings and increase the shareholder value, regardless of the uncertainty of interest rate movements and currency volatility in emerging markets.