Strategy Note /

The emerging market banks that can best hedge equity investors' currency risk

  • US dollar strength has put pressure on selected EM currencies. Tapering and Fed rate hikes could extend the trend

  • Banks in Hungary, Thailand and Nigeria could help equity investors hedge these risks. We highlight OTP, Guaranty Trust

  • Based on REER mismatches, the most valuable bank currency hedges are in Nigeria, Trinidad & Tobago, Egypt and Kenya

The emerging market banks that can best hedge equity investors' currency risk
Rahul Shah
Rahul Shah

Head of Financials Equity Research

Rabail Adwani
Rohit Kumar
Tellimer Research
25 November 2021
Published by

The USD index has risen by 5% so far this year. Among major currencies, JPY has declined by more than 10% over this period. Within emerging markets, Latin America has been hard-hit by US dollar strength, with currencies in Argentina, Chile, Colombia and Peru all down over 10%. Eastern Europe (notably Poland, Hungary and Romania) has also suffered. But the Turkish lira has declined most, losing more than a third of its value, although it can be argued much of this is self-inflicted. With the US Federal Reserve slowing its bond-buying activity, and commentators looking for US interest rates to rise, currency risk could play a key role in emerging market equity performance over the coming months.

In this note, we examine the currency mismatch positions of leading emerging market banks. We highlight those names that could be used by equity investors to hedge currency risk and those that could expose equity investors to additional volatility. We also briefly examine currency fundamentals.

Key currency pressure-points

Banks take foreign currency exposure in their natural course of business

Most emerging market banks generate open foreign currency positions during their normal course of business; for example, they may issue hard-currency bonds, or they may provide foreign currency loans to exporters. Where such positions are structural, these banks can provide equity investors with either a hedge against, or additional gearing to, currency movements.

To identify such names, we have examined the balance sheet disclosures of 91 banks across 39 emerging markets. Banks with net long foreign currency positions could generate translation gains, lifting their shareholders' equity, if their home currency were to depreciate. This could provide investors in these banks with a measure of protection against local currency weakness.

Among our sampled banks, those in 26 countries have net long foreign currency positions, while in the remaining 13 countries they have net short positions on their balance sheets. The median net long position across our sample markets is 4% of shareholders equity. The banks with the highest net long foreign currency position (relative to shareholders' equity) are in Hungary, the UAE, Thailand, Nigeria, and Trinidad & Tobago. Turkish banks have the largest net short positions.

Note that our analysis excludes off-balance sheet foreign currency positioning; this is for two reasons. Firstly, disclosure levels of such positions are less extensive. Secondly, we think off-balance sheet positions are less likely to be structural to the banks' operations, and hence less relevant for the exercise we are conducting. Derivatives positions are typically short-term in nature, while the bank's balance sheet foreign currency exposures could be of multi-year durations.

Net foreign currency position of sampled emerging market banks

Two-thirds of our sampled banks are net-long foreign currency

Switching to company comparisons, 59 of our 91-strong sample is net long foreign currency. OTP Bank (Hungary), Guaranty (Nigeria) and National Bank (Bahrain) have the largest net long foreign currency positions (as % shareholders' equity). In contrast, QNB Finansbank (Turkey), Sun Financial (Taiwan) and Credit Bank of Moscow (Russia) have the largest net short foreign currency positions in our sample. Being net short foreign currency can also work to an equity investor's advantage, for example where a currency is undervalued and has scope to appreciate. We consider this aspect in the second half of this note.

Net foreign currency position of sampled emerging market banks

The most misvalued emerging market currencies

Looking at real effective exchange rate (REER) positioning across emerging markets, many currencies are at sizeable deviations from their fair value. The most overvalued currencies on this basis are the Bangladesh taka, Egyptian pound and Kenyan shilling. The Lebanese pound is highly overvalued at its official rate but at the market price of c24,000, it is actually substantially undervalued. Other undervalued currencies on a REER basis include the Turkish lira, Argentine peso, and Brazilian real.

Currency over/ (under) valuation

However, currencies can stay misvalued for long periods as other factors also come into play such as reserves, external debt, current account, and inflation. For example, the Turkish lira appears heavily undervalued based on REER, but factors like monetary easing, high external debt and doubts about the policy framework and central bank independence are currently taking precedence. In the Appendix, we have looked at some relevant quantitative metrics and present a simple relative ranking of currency risk on this basis. Based on this framework the currencies most at risk of depreciation include the Tunisian dinar, Egyptian pound and Kenyan shilling. Currencies with the potential to appreciate include the Taiwanese dollar, Russian rouble and South Korean won.

Where foreign currency hedging through banks could have the most benefit for equity investors

Comparing banks' net foreign currency position with the over/(under) valuation of currencies against their REER fair values allows us to identify banks offering the best hedging potential. Looking at the scatter plot below, the banks in the top-right and lower-left quadrants can help boost equity portfolio performance if these currencies normalise to REER fair value.

For overvalued currencies, banks with net long foreign currency exposures can help to offset the effect of future currency depreciation. Banks in Nigeria, Trinidad & Tobago, Egypt, Kenya are particularly interesting in this context.

For undervalued currencies, banks with net short foreign currency exposures could help give an additional boost to future currency appreciation. Banks in Russia and Turkey appear most relevant from this perspective.

In contrast, banks in the other two quadrants (upper-left and lower-right) could act as a drag on equity portfolio performance if currencies were to move to their REER fair values. Hungary’s OTP and Taiwan's Sun Financial stands out on this basis.

The bank sectors that could benefit the most from full currency normalisation

In the chart below, we drill down to the individual bank level. We also adjust the axes so that the x-axis measures the hedging effect on each bank's shareholders' equity (assuming the local currency moves to REER fair value) while the y-axis measures the total effect on shareholders' equity (ie currency movement + hedging effect).

The sampled banks that would deliver the biggest hedging benefits (ie are to the right of the chart) are:

Europe: QNB Finansbank (Turkey), Akbank (Turkey), Garanti (Turkey) and Central Bank of Moscow (Russia)

Latin America: FirstCaribbean International and Republic Financial (both in Trinidad & Tobago)

Africa: Guaranty Trust (Nigeria), Zenith Bank (Nigeria) and Commercial International Bank (Egypt)

Middle East: National Bank (Bahrain)

Asia: ICBC (China) and Fortebank (Kazakhstan)

However, the hedging/gearing effect is smaller than the overall currency move in almost all cases. That is to say, emerging market equity investors typically cannot use bank shares to fully offset currency risk.

Impact of full currency normalisation on shareholders' equity

Appendix: Currency risk indicators

In the table below, we consider key currency indicators for each market: REER overvaluation, foreign reserves (expressed as months of imports), external debt (as % GDP) and the current account deficit (as % GDP). We present relative positions of markets for each indicator in terms of risk to currency devaluation; green= low risk, magenta = high risk. Weighting each risk indicator equally allows us to provide an overall risk rating for each currency.

Based on this approach, Tunisia, Egypt and Kenya have the highest risk of currency devaluation. In contrast, the currencies of Taiwan, Russia and South Korea could have scope to strengthen.

Selected currency risk indicators