Is value emerging in emerging currencies?
Emerging market currencies as an asset class have fallen by nearly 40% versus the US dollar since 2011. However, while there are undoubtedly bargains to be found, we cannot make a blanket case for buying on the basis of deep discounts today.
We have argued in the past that emerging market currencies have adjusted in a manner that is consistent with the terms of trade shock they have suffered. This is confirmed by a standard model of currency valuation that links a country’s exchange rate to a set of economic fundamentals. These include its inflation and productivity growth relative to trading partners, its terms of trade and its government consumption.
We estimated this model for 27 emerging markets (and 22 developing markets) over the period from 1990 to 2014 and then used it to predict the degree of currency misalignment in early October 2016.
The figure below suggests that emerging market currencies remain only slightly undervalued from a fundamental perspective. This implies that the depreciation of nearly 40% that we have seen versus the US dollar since 2011 has largely been driven by fundamentals rather than overshooting.
The best we can say is that there is no obvious overvaluation apparent today. However, for long-term investors in emerging market local debt, this could well be “good enough” given the high yields available. With ultra-low interest rates in developed markets, the yields available on government bonds in emerging markets remain enticing with the standard index currently offering over 6%. Over the long term, interest accrual is just as important as (potential) currency appreciation in generating returns for investors.