The current low interest rates in the US, Europe and the major emerging markets are pushing the yield hunters to explore more exotic places beyond the investment grade horizon. Thus, Frontier Markets are ahead of the possibility of unprecedented levels of foreign capital inflows. Below is more perspective what this could mean for the frontier economies of Africa, the Middle East and Central Asia.There are now multiple players at the world economic table and competition amongst them is clearly on the rise. Brazil’s finance minister recently coined the phrase ‘Currency Wars; a combative way to name the recent trend of major countries keeping currencies low in favour of competitiveness in the global trade arena.
As long as the US allows the dollar to devalue by expansionary money printing and fiscal policy implementation, it seems likely that some emerging and frontier market economies will see their own currencies appreciate versus the US dollar. We need to be careful not to generalize nor simplify things too much here.
First of all, a weaker dollar may well result in further enhancing already existing competitive advantages in some frontier economies, this is especially true for the Gulf countries that have a formal peg to the dollar. A weak dollar should be seen as a bonus for those places that already have an advantage in pricing power as it would only make them even more competitive. What about the countries that have debt outstanding denominated in US$? It goes without saying why a weaker US$ is to be regarded as a big positive in these cases.
Even for those frontier economies that may see their currencies pushed to higher levels, while they may see some of their international trade competitiveness erode, it will likely further highlight internal demand. Let’s not forget that internal demand was already strong enough to help most frontier market economies avoid the 2009 recession and continue to expand while the majors were contracting.
The IMF reckons growth in emerging markets will average a level of 6.4% in 2011, compared to 2.3% for in the developed markets. For frontier markets this means is that foreign capital inflows are likely to remain buoyant, adding further weight to currency appreciation pressure. According to the IMF’s Purchasing Power Parity measure, the currencies of emerging markets are overall undervalued by 31%.
Today, most nations are now seen to be actively dampening their currencies: Japan intervened for the first time in 6 years to protect the country’s exporters from the rising yen. China, Brazil, Switzerland, as well as the UK have encouraged their respective currencies to weaken. Once countries see their trade partners grinding away at their currency advantage, the possibility of protectionist capital controls and trade barriers looms, not to mention the threat of “competitive devaluation”.
The action of Brazil to impose a tax on foreigners’ fixed-income investments led some commentators to suggest that other frontier market policy makers will join in the so called currency wars. The tax was imposed in order to avoid international speculation and to weaken Brazil’s currency as Brazil’s Real rose 70% in value since 2005! Although such taxes have no support in conventional economic theory, they can prove attractive to vulnerable and illiquid countries that do not have an independent central bank. In the case of Brazil the impact of the above on its currency has been muted as investors tend to simply adjust bond prices to “price in” taxes.
It is less likely that this scenario will repeat itself in the frontier economies where local investors dominate the financial markets – foreign participation in the Frontier local bond markets is on average only around 5-10%. They welcome higher levels of foreign investment as they still need to build out a representative yield curve as a gauge for a modern economy.
However, currency volatility can hit remittances to Frontier countries which in some cases form a major source of capital inflows. Then again, the importance of remittances will eventually subside as most of these economies are in the high gear of development resulting in much of the Diaspora returning back home, there are simply more opportunities there than in the old developed world where immigrants are feeling increasingly unwelcome.
The impact on reserves is a simple measure of the direct effect of currency wars. South Africa’s gross reserves climbed 2.2% in September as the gold price rose and a weaker dollar boosted the value of euro, pound and other currency holdings. These now stand at $44.07bn. Nigeria’s foreign reserves, which peaked at $62.24bn in mid-May 2008, have depreciated by over 43% since then, closing last week at $35.24 billion. At least, to a certain extent, the impact can be measured in Nigeria. It would be great if anyone could run us through the math of what the real impact or cost will be of all the money printing, bail outs and interventions in the US and Europe…
In essence, the frontier market policy makers are faced with the possibility of sharply increased capital inflows. Most investors from the developed world are still largely underweight in emerging markets and often still not even invested in Frontier markets. The ongoing headlines of weaker major currencies may serve as a catalyst for some to cross the ‘frontier’ into new markets. The IMF estimates that emerging market equity holdings amount to only 2% of total US equity holdings, yet emerging markets represent up to 16% of total market capitalisation. Given that the Frontier markets represent no more than 4% of the main emerging market debt indices, one can only conclude that, the allocation to the frontier markets is still miniscule, with monumental growth potential.
So the risk is a torrential flood of inflows which may lead policy makers to intervention. By definition, this also points to currency appreciation. There is a great opportunity for investors who get in early: growing economies, rising currencies, an opportunity to learn new things about new places, what more does one want anyway?
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