Emerging market currencies sound dangerous. They go down quickly and with great fanfare, often after the finance minister’s denials that such a thing could never happen. Exchange rates add risks to emerging market equity and bond investments that are already risky enough. And to be worse, there is little intrinsic value in holding them, either for return or consumption.
These are the popular views about emerging market currencies. But there is as much that is right about them as is wrong. This short essay removes some of the hype and focuses on the facts a global investor needs to know to make prudent decisions about emerging-market exchange rates.
Fact 1: For every emerging market devaluation, there is an equal but offsetting revaluation.Emerging currencies get into the news when they hurt investment returns, but not when they help. As a result, we tend to notice only the downsides. But there are plenty of upsides too; in fact, it is surprising to learn that the upsides are of equal size. To demonstrate this, Figure 1 shows the range of returns from holding emerging currencies through the 1990s. Worst performers are memorable. Remember the Indonesia rupiah, which fell from 2,360 to 15,450 to the dollar during the Asian crisis, or the Russian ruble, which fell from 6 to 26.
Yet few people are aware that the rupiah provided returns of 112% in calendar-year 1998, or that the ruble earned 82% in 1995. These high returns occur through a combination of spot rate appreciation and high local currency interest rates. Thus, the fact is that there is plenty of risk in emerging currencies. But there is as much upside as downside risk. In fact there is a little more upside than downside. The horizontal lines in Figure 1 show the average return across some 30 emerging currencies. They are only two years in which they are negative!
Fact 2: Currencies affect one-for-one the returns on emerging market equities and bonds. The usual hope is that the currency changes “wash out,” ie, are offset by changes in local currency assets, so that there is no dollar or hard currency impact of the emerging exchange rate. This is not so. Currency changes are, on average, unrelated to changes in local currency equities. Sometimes when the currency falls, the local currency equity prices fall too, such as occurred in the Russian default and devaluation of August 1998. Sometimes, however, a decline in the currency is met with large local currency equity appreciations. Brazil is an example – by the time the government decided to let the real float (read: sink), the equity markets were so pleased that Brazilian stocks actually increased by more than the real was devaluated.
Fact 3: Active investments in emerging currencies can pay. Emerging currencies are distinct among asset classes – stocks, bonds, and major floating exchange rates – because their prices are not determined in a free market. Emerging market exchange rates are policy variables. They are controlled in some combination of dirty float, band, or peg. Governments want to increase their exchange rates in order to stabilize inflation; but they also want to decrease their exchange rates to promote competitiveness. The result is a tortured process in which the exchange rate is manipulated to suit conflicting policy objectives. When the other side of the market is focused on policy, and not on investment, it provides an opportunity to those who are. As a result, active emerging market currency investments can yield high returns relative to the risks the present.
Moreover, because these currencies are uncorrelated with the returns on other asset classes, a strategy of active investing in emerging market currencies adds little or no portfolio-wide volatility. At the same time, it increases portfolio return. Figure 2 gives an example, showing the improvement in an investor’s risk/return frontier from an active investment in emerging market currencies. A pure active strategy can increase return with a minimal impact on portfolio risk.
Fact 4: Hedging emerging market exchange rates is expensive, but selective hedging can reduce portfolio risk. The hedging of emerging market exchange rates can be accomplished through selectively hedging a combination of emerging currencies and developed currencies. The latter are inexpensive to trade, but provide somewhat less risk reduction for a portfolio of emerging market equities. The former can be expensive if hedging is comprehensive and passive. EMF recommends a combined approach, which uses emerging currency hedges sparingly and developed country hedges to cut risk. The red line in Figure 2 moves down and to the left to indicate the impact of hedging emerging currencies on overall portfolio risk and return.
Kenneth Froot is the André Jakurski professor of business administration and director of research at Harvard University’s Graduate School of Business. He is also managing partner of Emerging Markets Finance (EMF), an investment management firm in the US, and a member firm of State Street Associates, which specialises in emerging market currencies.