EM FX and Debt Outlook: USD Tide Turns

• EM FX will get a tailwind from the USD broader decline in 2023, as the Fed is seen pivoting towards easing later in 2023 and 2024. With the USD overvalued, scope exists for certain EM currencies to rebound and this includes the Brazilian real (also helped by higher interest rates) and Indonesian Rupiah (by a H2 recovery in commodity prices). The Chinese Yuan is seen making small gains, as the Chinese authorities will likely resist to strong a bounce that could undermine competitiveness.
• However, still wide inflation differentials for some EM countries will be a more important consideration (e.g. Turkish Lira, which is also likely to depreciate after the May election). Political worries ahead of the 2024 election will also hurt the South African Rand on a spot basis, where the ANC is set to lose its majority.
• On a total return basis for the remainder of 2023, the large interest rate differentials for Brazil and Mexico are an attraction and will likely ensure the best returns (Figure 1). The short-dated yield gap for South Africa versus the U.S. is not enough however to offset spot losses.

Risks to our views: More aggressive Fed tightening to 6% plus would cause a U.S. recession and an initial rebound in the USD and hurt EM currencies. The other key risk is that the U.S. imposes major sanctions on China for supplying lethal weapons to Russia, which would hurt the global growth outlook and Yuan/EM currencies – we see this as a modest probability risk.

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

Source: Continuum Economics. Note: Spot prices as of Dec 16

EM Asia FX: USD Decline Helps 

The Chinese Yuan has recovered against the USD, with the shift to the endemic COVID strategy. This can run somewhat further and we forecast 6.70 for USD/CNY by end 2023. However, China’s authorities will be reluctant to lose too much competitiveness to protect the net export position for the Chinese economy. The readjustment of some supply chains out of China are also an issue that argues against accepting too much of a Yuan bounce. Thus around 6.60-6.70 we see FX intervention as a high risk to cap the Yuan.

Meanwhile, elsewhere in Asia, emerging market currencies continue to prove resilient in the face of global uncertainty and financial market volatility. With the Federal Reserve continuing with its monetary tightening in the first quarter of 2023, Asian currencies remained under modest pressure. However, moderation in inflation, brighter economic growth prospects and government stability in these economies saw a return of foreign capital. India’s economy is expected to perform better than its peers in 2023, therefore the country is likely to see a further inflow of capital, which would provide a buttress. Even so, some downward pressure to the INR is expected to be sustained. This is owing to a persistent and wide current account deficit. Additionally, sustained high level of credit growth and still elevated inflation indicates some loss in value of the INR. As a consequence, we see the India Rupee (INR) declining further against the USD to INR83.2 by end 2023.

Figure 2: Indonesia Rupiah (IDR) and India Rupee (INR) against US$ 

Source:Datastream, Continuum Economics

The Indonesian Rupiah (IDR) got on to a strong start in 2023, climbing to IDR14897 against the USD, a 4.1% appreciation in early February. However, since then the currency’s performance has been slightly choppy owing to the unfolding Western banking crisis and the continued monetary tightening by the Federal Reserve. Bank Indonesia (BI) appears to be undaunted by the recent fluctuation in the currency (in the aftermath of the March rate hike by the Federal Reserve and the ongoing banking crisis in the West), and remains prepared to intervene should a need arise. The IDR is expected to perform relatively better than its Asian peers, but as the trade surplus diminishes over the course of 2023 (given a slowdown in global trade), the currency performance is likely to run out of steam. However, emerging market currencies (both the IDR and INR) are expected to perform better in 2023 given signs of the Federal Reserve tightening cycle ending and the USD weakening towards H2 2023. Consequently, we see the IDR appreciating over H2 2023, to IDR14920. 

Meanwhile, we expect the Malaysian ringgit to decline by about 1% in 2023, to 4.45 against the USD. Domestic politics, persisting Federal Reserve rate hikes, adverse rate differentials between Malaysia and U.S., plus global financial market volatility will see flows to other safe-havens. This is like to weigh on the currency, alongside our expectations of lower export earnings, which will hurt Malaysia’s currency.

LatAm: Strong Fundamentals but Volatility in Brazil

The Brazilian Real (BRL) has continued to show volatility in 2023. After dropping below the 5 level, USD/BRL is back again at the 5.25 area. There have been several political worries during this time as President Lula have been advocating for lower interest rates and a higher inflation target. Additionally, the new fiscal framework is yet to be presented by Lula’s economic team, and several ranks of the Workers Party have been advocating for a rule, which would guarantee more expenditures. We believe Finance Minister Fernando Haddad will present a credible rule, which is likely to please markets. Additionally, the Brazilian Central Bank (BCB) independence is set to be kept and the hawkishness profile of the BCB committee is set to keep interest rate at a high level during the whole 2023. The macro and broad outlook is that bonds and equities are cheap on a valuation basis and they will likely provide big returns in the next 9-21 months in Brazilian currency terms. We believe Brazil big spread between interest rates versus other countries, its geopolitical importance as the biggest LatAm country, plus environmental friendly policies, could give a good platform for the BRL to appreciate during 2023 on carry trades, portfolio trades and FDI flows. However, the political noises are set to continue as several members of Lula’s government will continue to blame the BCB and its orthodoxies measures for the poor growth in 2023. We believe the BRL is likely to finally reach close to fair value levels at 4.95 at the end of 2023, then see a small decline in 2024, finishing this year at 5.15.

Figure 3: Mexico Exchange Rate, 10-years Yields Spread and Policy Rate Spread with U.S.

Source: Datastream and Continuum Economics

The Mexican Peso has been performing better than we expected in our outlook in December. The strength of the MXN is related to two factors. One the less than expected tightening of the Fed and Banxico now tightening more than previously expected, which makes the expected spread between the two policy rates even higher. Additionally, Mexico have strong macro fundamentals, as the government debt/GDP ratio have been controlled due to fiscal policy discipline. Additionally, prospect of nearshoring would help to keep FDI at high levels increasing the overall strength of the MXN (here). We see the MXN keeping its overall strength and finishing 2023 at 18.5 on USD/MXN. For 2024, there is likely to be a small decline to 19.0 USD/MXN with some volatility as Mexico will hold general elections in this year.

In case of Argentina, we don’t see the many macroeconomic imbalances being solved and the country, which currently runs with 15 different exchange rate regimes, will likely continue to see strong devaluations. The official exchange rate finished 2022 at 177 USD/ARS, meaning a 70% devaluation in 2022. We believe the same is set to occur in 2023 as dollar shortages will worsen as there have been reports of several droughts in the rural areas indicating that the harvest of grain in 2023 will be worsen, which will then, reduce exports and dollars accumulation by the BCAR. Our forecast for the exchange in 2023 is 270. In 2024, as we see a new government imposing readjustment to the Argentine economy and we see the devaluation pace to slow down and Argentine currency finishing this year at 420 USD/ARS.

EMEA: Politics the Key

Local FX markets in Turkey and Russia continue to be dominated by interventions, capital control measures and hence suppressed pricing. Stability in Russian Ruble and Turkish Lira exchange rates have been muddled since late 2022, as monetary tightening in developed countries picked up pace and sustainability concerns arose. Furthermore, in Russia external balance deterioration caused by the EU oil price cap causing a depreciation of the local currency. 

In Turkey, the milestone will be the elections in May. Until then, current backdoor interventions and other controls to curb dollarization will be increasingly in place. In our main scenario where the opposition wins the elections, we see Lira depreciating gradually towards 23.7 against the US Dollar by the end of 2023 and to 27.1 by the end of next year. The Lira real exchange rate has risen rapidly in 2022 and early 2023, as the authorities slowed the nominal exchange rate decline. The policy shift after the elections will help restart foreign capital flows into Turkey. These flows will mostly be used to ramp up central bank’s FX reserves, which currently relies on bilateral swap deals with market participants and other country central banks. The gradual depreciation will be welcome as it will help restore some of Lira’s export competitiveness. In the alternative case, where the current administration stays in power, we expect further complicated approaches in the FX market as well. These may include the use of several different exchange rates to retail, corporate clients, as well as exporters and importers. Dwelling further into auxiliary measures instead of changing the policy approach by the administration in this scenario would lead to a sharp and damaging Turkish Lira decline correction by market forces.

Figure 4: CBRT FX Reserves ($ mn)

Source: CBRT, Continuum Economics. * Net reserves include SWAPs with different counterparties amounting up to $60.2bn

In Russia, the end of military action in Ukraine will not alter the economic and financial market outlook for foreign investors. Putin’s politics will continue to drive unamendable cracks between the West and Russia. The missing capital flows and demand for Russian energy will not be compensated by other parties, mainly because of weak infrastructure. Thus, the Ruble will remain under pressure, but the absence of foreign investors will limit the depreciation as USD/RUB moves slightly towards 82 by the end of the year.

In South Africa, local currency performance has been impaired by deteriorating local politics, economic outlook and the global monetary backdrop. The recent peak tightening of global monetary policy with worsening economic outlook priced leaves relatively less room for even sharper depreciation of the currency. Yet, as political uncertainty looms over in the rest of 2023, South African Rand will likely decline to 18.8 by the end of the year versus the USD. For 2024, Fed easing and decreasing political uncertainty after the elections in the second half of the year will help the currency reduce some of its losses as the exchange rate moves to 18.2.