Hot money exodus from emerging markets sends currency wars into reverse

Its all a far cry from a year or so ago,when emerging market exporters were battling rising exchange rates and Brazil was accusing Western policymakers of waging currency wars by flooding the world with cheap money. Turkey is now tightening its policy as the US Federal Reserve considers reducing the flood of cheap money that has stoked the investment boom in emerging financial markets.

Across most of the developing world,outflows have gathered pace leaving many currencies at multi-month or multi-year lows.

Swaps are pricing in 250 basis points of policy tightening in Turkey in the next three months,140 bps in Brazil,75 bps in South Korea,half a percentage point in South Africa and a quarter point in Poland. While rate rises of such magnitude might be unlikely,the fact is that a Fed-imposed monetary tightening is gradually taking hold. Emerging markets could be pushed to tighten policy to ward off capital outflows,South Koreas central bank governor Kim Choong-soo admitted last month.

When Brazils finance minister Guido Mantega complained about currency war,he didnt think that in a few months,the war he would be fighting would be to strengthen the real, UBS strategist Manik Narain said. Emerging markets have imported US monetary policy for five years but they havent imported the recovery. Now the Fed is effectively tightening so they too are forced to tighten.

With economies already weakening,policymakers will be reluctant to tighten policy. Instead countries including India,Russia,Indonesia,Peru and Poland have been selling dollars. But some,such as India,Turkey and South Africa,have little hard currency to sell given import needs and outstanding external debt,whether corporate or sovereign. Those that have an inflation problem or large oil import bills in dollars – such as India or Turkey simply cannot risk letting currency weakness go too far.

And central bank interventions are less efficacious once market appetite turns. Brazils real,for instance,is down 10 per cent in two months even though the central bank has sold $20 billion in derivatives in this period.

Given the scale of capital inflows into emerging markets $4.2 trillion since the Fed first started its money printing,according to the Institute of International Finance it is easy to see why central banks are jittery. Turkey,for instance,has a balance of payments deficit of around $50 billion a year.

To see what a difference emerging currency moves are making to unhedged investors,check out returns on Turkish assets. Lira-denominated bonds are broadly flat on the year in local currency terms,JPMorgans GBI Index series shows. But a dollar-based investor would have lost 3.5 percent already in 2013.