Emerging Market Asset Classes: Interest Rates and FX

When it comes to investing in emerging markets, professional investors have traditionally regarded interest rates and exchange rates as two primary asset classes. What are the main drivers and investment considerations for each? We engaged in a discussion with Yury Zusman, an emerging market strategist and the author of "EM Dynamics," to delve deeper into this topic.

Interest rates as an asset class

Hedder: As an asset class in emerging markets, what exactly are rates and what are the main drivers? 

Zusman: When I look at the rates market, I’d define it as local government bonds in local currency.

In terms of drivers, it breaks down into two segments here. First there’s monetary policy, and then there’s fiscal policy. 

Let’s look at monetary policy first. Government bonds in local currency in principle have low default risk because the government can always print money in order to repay debt in local currency. So the main consideration here is not the default risk, but rather the expectation of interest rates and the direction of interest rate trajectory into the future – which are driven by the monetary policy. 

For an inflation targeting regime, its monetary policy is driven by inflation and growth, with inflation being the number one goal. Normally, the central bank will raise interest rates when inflation is above its target. On the flip side, it will lower interest rates when inflation is within or below target, and then it kind of shifts gears in order to stimulate growth rather than focusing on inflation. 

And so, whenever you have any kind of surprises in inflation, that will be important for the local currency bond market. Many people spend a large chunk of their time monitoring the central bank and what the central bank will do, and trying to anticipate that in order to position properly for moves in local currency bonds. 

Then there is the fiscal element. The fiscal policy can be important and then important for two reasons. Number one, there's an interplay between monetary policy and fiscal policy. And whenever the government runs a deficit, this is considered loose fiscal policy because the government spends more than it receives, and that spending flows into the economy and stimulates economic activity, and that can translate into inflation depending on where the economy is in the business cycle. 

And if the government runs a fiscal policy that is too loose for where you are in the business cycle, the monetary policy will aim to offset that. They will try to raise interest rates, maybe, or keep them higher than they would normally do if the government is running large deficits. From that perspective, fiscal policy affects monetary policy.

FX as an asset class

Hedder: Moving on to FX, how do investors approach the trade? 

Interest rate differentials

Zusman: The FX market is driven by interest rates as one of the main factors, but it's driven by the very short term interest rates. It is important to note that the FX market does not have what you call the duration risk that the local currency bond market has. A duration risk is the sensitivity of the price of the asset to changes in interest rates. And the longer the maturity of the asset, the more sensitive it is to changes in interest rates.

So the focus of the FX market is more on the very short maturity – one to three months, as there's no duration risk. It has slightly different drivers because of that. 

Interest rate is an important factor, but we're talking about the differential between the interest rates in one country versus another country. So the FX market is always measured against another country. You have for instance, Hungarian Forint, which is measured against the euro, the dollar, or the Japanese yen. It's always relative to another country. 

In a way, you have to also look at the differences between those countries that you're comparing. One of the key differences is the differential in the interest rates, the very short interest rates. 

For instance, in Hungary, the policy rate is 12.25%, and that's compared to 5.25% in the US. So that's a 7% difference, and that's considered a pretty high difference. That will be attractive to investors who want to borrow in US dollars and lend in Hungarian Forint, and they will collect the difference.

Whenever that differential changes, it will attract capital flows into the country. Let's say Hungary suddenly raises interest rates; it’ll be attractive for carry traders to come in and buy Hungarian assets, short term assets. That will lead to a strengthening of the Hungarian Forint. 

Hedder: How about economic growth? How does that impact FX? 

GDP growth differentials

Zusman: Another important factor for FX is GDP growth differentials. And the reason is that the potential GDP growth over the long run is important for local asset class returns, including equities and bonds

For equities, it's important because the higher the long-term growth, the more revenue local companies collect. For bonds, it's important because higher growth will likely lead to higher interest rates. And interest rates, on a long term basis, are a very explicit measure of the return that investors receive. And so, that growth differential is important because the higher the growth in the country, the higher expected return is for the local asset classes. That will in turn increase capital inflow: when investors want to invest in a country, they will first buy the local currency, and then buy the assets of the country. 

Hedder: Are there any other macro factors that are important?

Balance of payment

Zusman: The balance of payments is also important. At a basic level, there's the current account and there's the financial account. The current account gives you an overview of the macro economy. It's the external side of the national economy, and is driven by net exports. This includes how much the country exports versus imports, and how much interest payments the country makes on its foreign debts. There's also something called remittances where nationals or migrant workers living abroad send money to their families in the country. This can be a major driver of inflows of foreign currency for a number of countries like Mexico, for instance.

On the flip side, you have the financial account. Financial account is all about capital flow: foreign direct investments, portfolio flows, investors putting deposits into local banks, and so on. As an accounting rule, the financial account has to balance the current account. If you are importing more than you are exporting, you need to borrow from abroad in order to finance those imports. And that's done through the financial account – through issuing debt or equity, or attracting long-term FDI in the form of private equity or private debt. 

A third element that feeds into the balance of payment picture is international reserves. This is generally part of the financial account, but it is often looked at separately because it is driven by policy. It is determined by the central bank actions, instead of the private market factors that are driven by decisions to make profit and decisions to maximize returns. The central bank makes decisions based on policy. 

For instance, if the country imports more than it exports, the central bank can decide it needs to attract capital in order to finance the imports. But it cannot attract capital out of nothing. It has to offer some kind of return for the capital to come in. 

And maybe the return is not high enough – so you can actually split the return into two parts. You could have the return that comes from the local asset from equity and paying dividends. And then there's the return from foreign currency. If an investor looks at an asset inside another country, it will need to convert its own currency into the local currency and then buy that asset. It will earn some return on that asset, but then it might gain or lose on the currency. And perhaps you could have a situation where the local currency return might be fine, but the investors think that the currency itself is overvalued. And so, they would expect it to depreciate and detract from some of the local currency return. So that picture might not attract enough capital to finance the imports.

Hedder: Are there any examples from EM that can illustrate these FX drivers? 

The case of Egypt

Zusman: Let’s look at Egypt as an example. Egypt is heavily reliant on the imports of basic goods and products. It imports more than it exports. And the average household consumption is dependent on these basic goods. So a large part of their spending goes towards the purchase of items like food and energy. When you are importing a lot of these basic goods, the exchange rate becomes an important factor on how much the average household will spend. If the local currency depreciates, it hurts the average household. So Egypt is politically a lot more sensitive to exchange rate depreciations, and they often try to maintain it at a certain level.

Last year, Egypt needed capital in order to finance its excess of imports. At the same time, the macro environment deteriorated as geopolitical risks materialized and investors became more risk averse. So Egypt couldn't attract the capital that it needed in order to finance these imports. In order to maintain those imports, the central bank would sell its international reserves. Those dollars that were needed to buy imports came from the central bank instead of foreign investors. 

Alternatively, if a central bank did not want to spend its reserves, then something had to give. The current account always has to balance the financial account, and what makes it balance is the exchange rate. If the imports are not fully financed by capital flows, the exchange rate has to adjust. But when the exchange rate weakens, that compresses the domestic demand, and people cannot afford the same level of imports. 

Potentially, after a certain period if the exchange rate is weak enough and if the central bank hikes interest rates, that may attract capital flows back to the country. But that requires an exchange rate depreciation, which is very politically sensitive in a country like Egypt. That may be a reason why the central bank may not want to allow the exchange rate to depreciate and will spend its reserves in order to protect that. 

But the problem here, of course, is that reserves are not indefinite. Central banks hold a limited amount of reserve reserves. If it continues to support the exchange rate in this manner, it will run out of reserves. Then the country won't have any dollars left, and it will lead to potential default on debt that cannot be paid.

Ultimately, Egypt could not continue to support its exchange rate, as it was running out of reserves, and the government let the currency devalue.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.