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Rounding off the FX series with the best of the bunch.
If you enjoy volatility, pain, and always go back to your crazy ex for more, then these are the currencies for you!
What defines a currency as Emerging?
To be honest, it's a pretty broad term.
Typically, demographics are a big part of the picture
A young and growing population = a young and growing economy (i.e. an emerging/developing economy) 👇
Funky animated version of how populations evolve and age 👇
Why start with demographics?
A young and growing population = a young and growing economy.
For example: Established companies (usually foreign) will invest by opening mines or factories in an emerging country and train up a young, willing (cheap) workforce.
Where one company leads, others will follow...
"Hey there, looks like you're building a factory, you'll need some better roads to get those goods in and out, let's talk!"
And everything ripples out from these initial investments.
The economy grows and develops quickly. But that expansion comes at a cost...
The developing nation takes on debt to grow. Much of this debt is usually dollar-denominated and/or foreign debt.
As long as the economy's growing, everything's great.
Investment continues to flow in, the country gets richer, domestic industry improves, social systems develop and the country goes from developing to developed.
That's the theory at least.
In reality, emerging markets tend to follow a repeating boom and bust cycle...
The economy takes on a load of debt to expand, then some kind of event happens which forces a de-leveraging, some investors lose money. Everything gets restructured before the economy (hopefully) reflates and grows again.
Emerging markets are usually hyper-sensitive to the global economy.
If these currencies are pro-cyclical... 👇
Then emerging market currencies are hyper-cyclical. Especially those that are closely tied to commodities.
One BIG difference between developed market cyclicals and EM's is the politics.
Generally, developed economies have well-established political systems with a stable rule of law.
In short, it's far less likely that some autocratic nutter can take complete control of the political and monetary system and/or carry out huge economic experiments with no basis in sound economics.
On an entirely unrelated note:
The Turkish Lira (TRY)
Turkey's Lira since 2013:
Gradually losing value ➡ Rapidly losing value ➡ Full-on collapse mode... 👇
What's going on?
President Erdogan believes that the best way to slow inflation is by lowering interest rates.
It's known as Unorthodox Monetary Policy because it flies in the face of the economic theory that higher interest rates cause inflation to fall.
Investors are used to unconventional approaches in emerging economies, it's all part of the game.
The lack of central bank independence is a problem though. An independent central bank would not be compelled to follow Erdogan's unconventional policy.
In Turkey, it's Erdoganway or the Highway 👇
Everything in orange is Erdogan's intervention in central bank decision-making.
From an investor's perspective, an autocratic leader, high inflation and decreasing interest rates do not make for an attractive investment proposition.
This fuels a lack of confidence to invest in Turkey which in turn, has led to the fall in the Lira.
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Politics plays a much larger role in Emerging Markets than it does in Developed Markets.
The legal institutions are fragile, and the wide inequality divide leaves plenty of space for populists to grab power, often riding a nationalist wave and pledging to punish the foreign companies that are 'exploiting the country'.
It's easy to blame outsiders.
Problems arise when the government moves to confiscate foreign assets or attempt to forcibly nationalise foreign businesses. This will usually lead to international trade sanctions and/or lower access to capital markets...
Which makes it harder to pay existing loans... and so the doom loop continues.
The Role Of The Dollar
Once again, the dollar is massively important.
Firstly, US interest rates set the benchmark for the world. The US 10Y yield is considered the global 'risk-free' rate and used as a benchmark for valuing every other asset.
Investor: "I get 2% risk free for parking my money in US treasuries. If I'm going to invest into anything riskier, I need to be compensated for that extra risk" (risk premium).
An investor and the boss of a car insurance firm have a lot in common...
- Older drivers, stick to the speed limits, full no claims = US Treasuries
- Younger drivers, what speed limits? YOLO! = Emerging Markets
Just like the investor, the insurance company demands a much higher risk premium to insure the younger driver.
The higher the risk, the higher the premium. Financing can be very expensive for emerging economies.
Then there's the dollar-denominated debt.
A stronger, more valuable dollar makes those loans more expensive to service, and increases the risk of default.
Returning to a typical market cycle, think about what this means for emerging markets.
As the cycle ends, investors become more risk averse, sell out of their riskier investments and buy dollars.
This reversal of capital flows out of EM currencies and into dollars is a double whammy. 👇
- Less investor capital available due to risk aversion
- Exchange rate weakens which makes dollar debt-servicing more expensive
Which is why Emerging Markets are especially vulnerable at the end of global economic cycles.
We'll take a deeper look at a few Emerging Markets in the final installment....
The rest of the FX series here 👇
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