By Alex Frangos
The Wall Street Journal
January 3, 2011
Currencies of emerging-market and commodity-rich countries went on a tear in 2010, but the bull run exposed imbalances building in the global system of foreign exchange that promise to hover over markets in 2011.
Investors unwilling to accept low interest rates in the U.S. and Europe this past year sent money into countries where growth prospects are better and interest rates more rewarding. As a reflection of that flow, emerging nations had accumulated $1.2 trillion in currency reserves between the financial crisis's peak in early 2009 and the third quarter of 2010, according to the International Monetary Fund.
In October, the Australian dollar, which benefits from Chinese demand for Australian mining resources, breached parity with the greenback for the first time since it became a free-floating currency in 1983. The Taiwan dollar hit an all-time high in late December and closed the year at 29.17 to the dollar.
The Malaysian ringgit and Thai baht rose around 10% against the dollar, to their strongest levels since the Asian financial crisis in the late 1990s. The South African rand was up 14% versus the dollar. It was a minor currency, however, that was the world's best-performing: Mining-rich Mongolia's togrog finished the year 15% higher against the dollar.
At the center of the rise of emerging-market and commodity currencies stood China. That is set to continue in 2011.
Other emerging-market economies compete with China on exports and intervene routinely in currency markets to prevent their currencies from rising quickly against the Chinese yuan, which Beijing controls tightly. And China's demand for raw materials spurs economies in Australia, Brazil, Canada, South Africa and much of Asia.
"China is gigantically important," said Simon Flint, foreign-exchange strategist for Nomura Holdings in Singapore. "The pivotal relationship in the global economy exists between the U.S. and China. While there's high unemployment in the U.S., there will be tensions between the U.S. and China. The way these two countries behave will affect the way the rest of the emerging world responds."
China altered its currency policy in June 2010 and began to allow gradual appreciation of the yuan for the first time since July 2008. By the end of the year, the yuan had risen 3.6% against the dollar.
Still, China's go-slow appreciation hasn't been enough for its biggest trade rivals, which spent billions buying dollars and selling their currencies in foreign-exchange markets. The aim was to prevent their currencies from rising so quickly that their exports became less competitive against China's.
In so doing, Asian economies outside China, for instance, built up $241 billion in hard currency reserves in 2010 through November. And it still wasn't enough to prevent most emerging-market currencies from returning to precrisis highs against the dollar.
While investors in these "growth" currencies enjoyed all-time or multidecade highs, government policy makers in emerging economies grew increasingly concerned that the flood of cash will make their currencies uncompetitive and pump up inflation and asset prices to bubble territory. Many routinely intervened to tamp down further rises and have taken measures to limit the flow of capital.
This situation, coming at a time when developed countries are still struggling with sluggish growth and yawning deficits, sets the stage for a tug of war in which an unpredictable mix of market forces and government policy drive currency markets this year.
In addition to direct intervention in currency markets, governments in economies such as Brazil, Thailand, South Korea, Taiwan and Indonesia resorted to more-controversial tactics known as capital controls, or restrictions on the flow of money across borders through means such as investment taxes and required holding periods for foreign investors.
Emerging-market policy makers portrayed their use of capital controls as a response to the Federal Reserve's $600 billion extension of its so-called quantitative-easing program. The monetary stimulus seeks to keep long-term interest rates low and prevent the U.S. economy from re-entering recession. But it also has the potential to overwhelm smaller economies with a flood of investor cash.
Concerned that so-called hot money will disrupt efforts to keep their economies growing on an even keel, several emerging-market nations, such as South Korea, Indonesia, China and Brazil, won language in a Group of 20 communiqué in November that gave diplomatic license to use such tools. In the past, capital controls were seen by developed nations as dangerous manipulations of the free market.
Many think the flow from developed-market currencies into emerging-market ones is a long-term trend that will continue in 2011. Investors swelled fund manager Pictet & Cie.'s Asian local currency bond fund, for instance, from $125 million in November 2009 to $1.6 billion a year later.
More investors are set to follow the trend. Xavier Baraton, global chief investment officer of fixed income for HSBC Asset Management is adding emerging-market local currency bonds to his firm's global high-income bond mutual fund 2011. The fund formerly only invested in dollar-denominated emerging-market bonds.
Skeptics, however, see signs that the flow to emerging markets could reverse in 2011 and catch investors off guard. Inflation, which erodes a currency's value, is building in China, Indonesia and Brazil. Renewed optimism about the U.S. economy and suddenly rising interest rates in the U.S. has the potential to suck money back into the dollar.
"A more robust U.S. economy makes the U.S. a more attractive place to invest," says Patrick Perret-Green, currency strategist for Citigroup in Singapore.
Another issue is whether emerging-market and commodity currencies will withstand future global shocks better than in the past. After Lehman Brothers collapsed, these "risky" currencies fell significantly against the dollar.
During the euro crisis in the spring of 2010, the flight-to-safety pattern repeated itself as investors continued to see the U.S. currency as a haven. To wit: The Australian dollar fell 12% between April and June; it later bounced back, reaching its all-time high, and ended the year stronger than the greenback at $1.02.
"If something does go wrong, the Australian dollar is likely to depreciate a lot," says Adarsh Sinha, foreign-exchange strategist at Bank of America Merrill Lynch.
