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Emerging market currency valuation amid US dollar strength

  • US dollar index (average of $ vs. main global currencies) and US real effective exchange rate (REER) at 10-year peaks

  • Drivers are US rate hikes and global risk aversion (slowing growth, EU energy crisis); much of EM suffers as a result

  • Cheap FX + equities: large EM Brazil, Indonesia, Korea, SA, Thailand; small EM Chile, Colombia, Hungary, Pakistan, SL

Emerging market currency valuation amid US dollar strength
Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

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Tellimer Research
15 July 2022
Published byTellimer Research

We are in an era of dollar strength: the US dollar currency index (the average of US$ versus the main global currencies) and the US real effective exchange rate (REER) are at respective decade highs.

The drivers are US rate hikes and global risk aversion, specifically slowing global growth (including China), the EU's energy crisis and insecurity spillovers from the Russia-Ukraine War, and the continuing role of the US dollar as the dominant reserve currency.

Much of the emerging market universe is suffering as a result, which is evident in the depreciation of most FX rates in EM year to date.

US Dollar gain is a pain for most emerging markets

In this report, we review FX changes year to date, REER valuation and equity valuation across emerging markets. The aim is to provide a guide as to where deep value resides.

The combination of a cheap FX rate and cheap equities is present in Brazil, Indonesia, South Korea, South Africa and Thailand in large EM, and Chile, Colombia, Hungary, Mauritius, Pakistan, and Sri Lanka in small EM.

This is very different from identifying the most important near-term market drivers for FX movements. For that, see, for example, External Liquidity Index (May 2022) from my colleague, Patrick Curran, and for an overview of EM equity strategy views, see US recession fear, China reopening hope (June 2022).

EM currency weakness

Emerging market currency declines amid US Dollar strength

Currency valuation in EM

We review FX valuation in EM, using third-party REER estimates, considering the upside to spot FX should REER revert to 100 or to its 10-year median.

FX change implied if REER reverts to 10-year median or 100

Currency and equities valuation in EM

We compare FX valuation (percentage change should REER revert to the 10-year median) and equity market valuation (trailing price/book relative to the five-year median) and observe the following.

  • Cheap REER and equities:

    • Large EM — Brazil, Indonesia, South Korea, South Africa, Thailand.

    • Small EM — Chile, Colombia, Hungary, Mauritius, Pakistan, Sri Lanka.

  • Expensive REER and equities:

    • Large EM — Saudi Arabia.

    • Small EM — Bangladesh, Iceland, Kuwait, Nigeria (official FX rate), Qatar.

FX and Equity market valuation comparison in EM

Our EM Index in this context

The data used in this report is regularly updated in our EM Investability Matrix dataset and currency risk is one of the inputs in our EM Country Index, which ranks global emerging markets and where weights attached to factors – spanning macroeconomic policy credibility, structural growth, politics, geopolitics and sanctions, ESG, and equity valuation and liquidity – can be adjusted.

Footnote on REER

The real effective exchange rate (REER) is the average of a country's exchange rate compared with those of its trading partners, weighted by the relative trade balance with each trading partner.

All other factors equal, a REER above 100, or an increase in REER, indicates less trade competitiveness, or over-valuation. REER well above or well below 100 can persist for a sustained period.

REER is merely an indicator of whether the current spot FX rate is cheap or expensive. Movements in spot FX rates are driven much more by balance of payment changes, eg trade and capital flows, than the perception of under or over-valuation.

Separately, the 'Balassa-Samuelson effect' (1964) describes how fast growth, in wages and productivity, in a tradable sector, eg Bangladesh garments or Vietnam electronics, can appropriately drive higher inflation across the economy and lead to FX rates which appear expensive on a REER basis. That may partly explain the persistent over-valuation versus REER observed in Bangladesh and Vietnam.