This week's furious selloff in emerging market currencies looks set to gather pace in coming days on signs that hitherto resilient domestic bond markets are finally crumbling under the weight of global risk aversion.
From the Korean won to the Mexican peso, emerging currencies in recent days have tumbled to multi-year or even record lows versus the dollar, putting at risk investment returns and reviving memories of the 2008 crisis when central banks spent hundreds of billions of dollars to defend currencies.
As panic over Greece and Spain pushes investors headlong towards the dollar, more pain is likely for emerging currencies.
Stock markets have taken a huge beating in May, turning in their worst performance in eight months. Remarkably, local bond markets have largely withstood the assault, with yields relatively stable since Greece's May 6 election raised the alarm about the country's commitment to the euro and Spain's banking crisis escalated.
But now mounting currency losses are becoming a drag on the performance of the main local debt index, JPMorgan's GBI-EM. While returns in local currency terms are still at a healthy 5-6 percent, dollar-based returns have dissolved to almost zero, from 11 percent at the end of the first quarter.
"As returns get impacted by the stronger dollar, funds are going to see more and more redemption pressures," UBS strategist Manik Narain said. He added: "As funds start selling bonds or hedging currencies, that could trigger a second wave of FX weakness."
With no indications of a large-scale rescue operation from the US Federal Reserve or China, funds have started selling. Data from EPFR Global shows EM bond funds have posted two straight weeks of outflows for the first time since January, losing $500 million in the week to May 30 and over $600 million the week before. Local debt funds have borne the brunt.
And exits tend to pick up speed once annual returns turn negative. During the last bout of emerging market weakness in September 2011, retail outflows spiralled on September 21, the day year-to-date returns on the GBI-EM fell into the red, JPMorgan analysts note.
The losses on the FX side are increasingly pressuring the Net Asset Value, or NAV, of emerging bond funds, analysts at Citi said, referring to a fund's per-share market value. NAV is usually computed on a daily basis and indicates how profitable a fund is relative to its assets. Based on a NAV composite of large emerging bond funds managing $27 billion in assets, Citi said the May selloff had caused NAV losses of over 5 percent, though on a year-to-date basis the measure remains marginally positive.
"Looking at past large dislocations on emerging market local currency debt flows, we believe the current NAV losses in the real money industry are touching a 'danger zone' in terms of potential 'forced redemptions'," Citi told clients in a note. "Current dynamics in emerging market FX clearly suggests more sizeable redemptions in local debt funds are looming."
Many reckon losses will be capped by positioning which seems lower than during the 2007 boom time or before last September's falls. Emerging bond funds have absorbed $28 billion this year, JPM data shows, but two-thirds of this went to dollar debt.
A client survey by JP Morgan in April revealed moreover that almost a third of foreigners' FX positions were hedged compared with just 15-16 percent last autumn, the bank said in a note. Cash balances were also at a high 4.4 percent, JPM said, while its survey showed crossover investors were underweight emerging local debt before the latest selloff erupted.
Nevertheless the bank advised clients to stay defensively positioned, noting high-risk events in the euro zone calendar, including a second round of Greek elections in mid-June. There is however one factor that could hasten fund managers' exit from local currency debt.
According to UBS calculations, emerging currencies have already fallen 10 percent since end-February on a GDP-weighted basis and FX volatility is at 12-month highs. But central banks for the most part have been relaxed about the depreciation. That's a stark contrast with 2008-2009 when they rushed to the defence of their currencies, even though the interventions cost them almost a third of their reserves. Russia's central bank, for instance, has barely reacted to the rouble's 5 percent drop this week while the Reserve Bank of India has stood back as the rupee has plunged to record lows.
One thing is for sure. Hopes at the start of 2012 for double-digit dollar returns from emerging market local debt now look doomed. "For emerging market local debt asset class to generate positive returns, stability in FX is required, which will be hard to come by as long as euro zone worries dominate," UBS analysts told clients.
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