EM FX Outlook: Divergent Prospects

• For 2024, we forecast a decline in the USD versus DM currencies and this should mean less pressure on EM currencies. However, the picture diverges across EM and account also needs to be taken of the prospect of lower inflation in the U.S. in 2024 than most EM countries. Moreover, EM currencies will likely use any phases of currency strength to reduce interest rates. Thus we do not see EM currencies getting much benefit from the movement in DM currencies.
• Indeed, the BRL and MXN peso will likely see losses in 2024 on a spot basis versus the USD, as their central banks cuts interest rates more aggressively than the U.S. Elsewhere, the South African Rand (ZAR) will likely see a modest bounce in H2 2024, as the country slowly gets to grips with power cuts.
• The Chinese Yuan (CNY) will also be a focus in itself and for all EM currencies. While we see a move to 7.60 on USDCNY in H1 2024 endorsed by China authorities to boost exports, the weaker USD trend should produce a H2 recovery to end 2024 at 7.40. This should limit the spillover to other EM currencies. 
• Risks to our views: A recession in the U.S. would likely mean a larger decline of the USD versus DM currencies and spillover to benefit EM currencies. Alternatively, a further surge in U.S. 10yr yields could help the USD generally, but also cause funding problems for weak EM and frontier countries.

Figure 1: Our Forecast for Total Returns by end-2023 (vs. USD)

Source: Continuum Economics. Note: Spot prices as of September 27

EM Asia FX 

Our view remains that China is willing to accept a slow and moderate decline in the Yuan to help exports but wants to avoid a quick move that could trigger capital outflows from China as in 2015.This means intermittently stopping the Yuan decline as a tactic to ensure a slow pace. We continue to forecast 7.45 on USDCNY by end 2023 and scope exists for this to extend in H1 2024 towards 7.60 (here). Looking at 10yr government bond yield spreads would be consistent with 8.00-8.25 on USDCNY, while short-end spreads are wider and consistent with 8.25.Capital controls means that this relationship is not as strong as currencies without capital controls, but it does have some impact. 

Additionally, though China is trying to restrain the Yuan decline, it does benefit the export picture. With residential property investment in a structural downturn, China authorities would prefer that exports make a contribution to growth. However, China exports have run out of steam, which is more than the slowdown in DM economies due to a shift of global supply chains and a softer Yuan helps to at least underpin exports.

As the Fed switches towards easing from Q2 2024, we would see the Yuan depreciation slowing then stopping. As cumulative Fed easing provides expectations of rate cuts into 2025, H2 2024 should see a bounce in the Yuan. Even so, China structural headwinds (slowing productivity/peak labor force); a multi-year hangover from the residential construction boom (here) and policymakers reluctance to ease aggressively suggests that doubts will linger over China and this should restrict the dip in USDCNY to 7.40.

Figure 2: 10yr China-U.S. Government Bond Spread (%) and USDCNY (%)

Source: Datastream, Continuum Economics

Meanwhile, in other parts of Asia, emerging market currencies experienced a period of instability in the early months of 2023 and again in the beginning of Q3. However, our projections suggest that these currencies are poised to remain resilient throughout the remainder of the year. While the USD is expected to remain strong, these currencies (such as the Indian Rupee (INR) and the Indonesian Rupiah (IDR)) will witness only marginal weakening from current levels. Over 2024 though, the EM currencies are expected to strengthen slightly or stabilize and this shift is primarily attributed to the anticipated weakening of the U.S. Dollar (USD) as the Federal Reserve concludes its tightening measures. Specifically, we expect the USD/IDR to close 2023 at 15,575. For end 2024, we expect the USD/IDR exchange rate to reach 14,990. This is largely due to lower U.S. rates seeing the USD decline from elevated levels.

In the case of India, its economy is anticipated to outperform its regional counterparts in 2023. Additionally, as a viable alternative to China, India is likely to attract increased capital inflows, providing a stabilizing influence. However, India’s current account deficit remains wide and investment flows volatile. Therefore, keeping in mind these dynamics, we expect the USD/INR to reach 82.5 by close of 2023. In 2024, we expect USD/INR exchange rate to reach 82.9. Overall, our expectation is that the INR will continued to fluctuate within in the 81-83.5 band over the next 15 months, as portfolio inflows counterbalance a higher inflation rate than the U.S. Nevertheless, it is essential to acknowledge certain factors that could temper the performance of these two currencies. Risks associated with upcoming elections, fluctuations in financial markets, and a deteriorating trade balance all pose challenges.

LatAm: Yield Gap to Narrow but Stability to Continue

The BRL has exhibited notable stability, hovering around the 4.90 mark in recent months, aligning seamlessly with our previous forecasts. This stability can be attributed to the government's efforts to restore investor confidence, resulting in reduced BRL volatility during the first half of Lula's tenure. A pivotal factor contributing to this stability is the substantial interest rate gap between Brazil and advanced economies. Despite the Brazilian Central Bank (BCB) embarking on a rate-cutting trajectory, the BRL has not experienced significant depreciation, primarily because Brazil still carries one of the highest interest rate premiums among emerging markets.

Brazil's robust FX reserves, amounting to approximately 20% of its GDP, coupled with strong exports of oil and agricultural products throughout 2023, have played a pivotal role in diminishing the current account deficit. Notably, Brazil finds itself in a rare position where its inflation rate is currently lower than that of advanced economies. Taken together, these factors lead us to anticipate continued BRL stability in 2023, culminating in a year-end exchange rate of 4.95 USD/BRL. Looking ahead to 2024, we foresee a modest uptick in the USD/BRL exchange rate to 5.10, primarily influenced by a narrower yield spread, as the BCB eases more than DM central banks. A potential risk lies in the perception of higher fiscal risks by investors in Brazil, which could trigger a more significant decline in the BRL.

Figure 3: Brazil Exchange Rate, 10-year Yield Spread, and Policy Rate Spread with U.S.

Source: Datastream and Continuum Economics

MXN has exceeded our expectations, demonstrating remarkable resilience. This strength can be attributed to two key factors: the substantial interest rate differential with the United States and the outstanding performance of Mexican exports, particularly to the U.S. The outlook appears favorable, with nearshoring prospects and Mexico's commitment to fiscal discipline potentially bolstering the MXN's strength. Additionally, the independence of Banxico, Mexico's central bank, adds to the positive sentiment. We anticipate USD/MXN to conclude the year around 17.4. For 2024, a modest decline is anticipated as the interest rate gap with the U.S. narrows, primarily due to Banxico's expected rate cuts being greater than the Fed’s. One potential risk is the possibility of higher U.S. interest rates leading to capital outflows from Mexico to the U.S., though we view this as a low-probability scenario. Our forecast for the MXN in 2024 stands at 18.4 USD/MXN.

Turning to Argentina, the country grapples with persistent macroeconomic imbalances, maintaining an array of 15 different exchange rate regimes. Continued devaluations seem likely, exacerbated by reduced access to dollars due to droughts in rural areas. Although rates will remain unchanged until the elections, a need for devaluation is anticipated post-October. We project the Argentine Peso (ARS) to close 2023 at 450 USD/ARS. In 2024, the pace of devaluation is expected to slow as a stabilization plan takes effect. Consequently, our forecast for that year stands at 680 USD/ARS.

EMEA 

Emerging market currencies continue to be under pressure as we are heading towards an election year in 2024 in South Africa, Russia and local elections in Turkiye. 

In South Africa, despite inflation partly easing recently, and the South African Reserve Bank (SARB) halting monetary tightening to ensure that the rate differential with the Federal Reserve remains modest, we think the pressure on the ZAR will remain high due to shrinking trade surplus, China’s slowdown and lingering inflation. (Note: The country’s trade balance in the 1H of 2023 showed a surplus of ZAR5.6 billion but is a deterioration from the ZAR129.6 billion trade balance surplus in the same period in 2022.) 

On the inflation front, we predict prices to pick-up slightly in Q4 ignited by strengthened loadshedding, global oil prices hiking and the ZAR losing value before a slow inflation decline in 2024. We see the ZAR weakening against the USD to 19.1 by end 2023. (Note: The REER of the Rand remains undervalued around 4% below the 5-year average). 

We think the end to SARB tightening and possible the start of easing in H2 of 2024 will help fixed income returns and the ZAR will likely stabilize helped by modest undervaluation on a real exchange rate basis. We see some moderate volatility during the year as South Africa will hold presidential elections in May-July as any ZAR recovery will be weak due to uncertainty about the 2024 election impact on policy. Additionally, the ZAR will likely still be supported by a trade surplus in 2024 coupled with probable FED and ECB easing. There are some rising risks over fiscal performance from election related spending and concerns over the power and logistics crisis. But an improving inflation outlook, decreasing political uncertainty after the elections, South Africa and China having recently signed agreements on cooperation in clean energy investments and electricity transmission, and SARB’s own domestic inflation sensitivity could mean a modest bounce to 19.0 on USD/ZAR by end 2024, as the currency could reduce some of its losses in 2H of 2024. 

Figure 4: Turkiye’s Current Account as a Percentage of GDP (%)

Source: Datastream, Continuum Economics

Meanwhile, we USD/TRY moving to 30 by the end of 2023, and further weakening to 37.5 in 2024 due to elevated inflation, increasing trade and budget deficits and low foreign direct investment (FDI) which continue to dent the currency. The budget deficit is causing fears in the markets that the government will start increasing spending before the local elections planned for March next year. We see losses for TRY in 2024 as the current account continues to deteriorate and foreign capital inflow remains weak (Figure 4). We think the authorities will also seek to boost exports and allow a build-up of international reserves by a soft currency to reduce persistent current account deficits. Trade imbalances may also worsen with the modest EU recession, as the EU remains the biggest trade partner for Turkiye. We are of the view that the Turkish authorities will likely have to accept a moderate pace of ongoing TRY depreciation as the inflation differentials are high and the country needs FX inflows, while we expect inflation differentials versus key trading partners will still be large in 2024. The Central Bank will continue to seek to regain credibility and restart foreign inflows through the shift to traditional economic policy moves including increasing the policy rate to 30% by the end 2023, but it will take time to restore confidence.

Like TRY, stability in Russian Ruble (RUB) continues to be muddled as monetary tightening has picked up pace and sustainability concerns remain. The RUB remains mostly uninvestable due to the ongoing war in Ukraine creating severe risks. Our forecast for USD/RUB by the end of 2023 and 2024 are 97.3 and 98.2, respectively, as we expect no immediate return by foreign investors once the war is over, and FX markets would be under pressure with current capital controls. Taking into account that the current account surplus is shrinking, inflation spiking, and presidential elections in March 2024 are contributing to the political uncertainty, we expect the RUB will remain weak. The authorities may intend to allow continued RUB weakness to sustain competitiveness and the CBR are likely to swing to rate cuts in 2024.