Emerging Currencies in a "ZIRP" World


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Near-zero short-term interest rate policies, or "ZIRP," in the U.S., Europe and other developed countries and regions is a "huge complication" for emerging markets, as India and others are challenged to balance growth with holding inflation in check, CME Group Chief Economist Blu Putnam wrote.

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Emerging Currencies in a "ZIRP" World

  1. 1. Market nsightsBy Blu Putnam, Chief Economist, CME Group December 18, 2012Emerging Market Currencies in a“ZIRP” WorldThe context of near-zero short-term interest rates move toward greater currency normalization; Brazil andfrom the United States, Europe, the United Kingdom, Mexico as they struggle to encourage economic growth;and Japan provides a huge complication for emerging and Russia as it manages its oil revenue risk.market countries in terms of the potential interplay of Our conclusion is that markets are entering an especiallyexchange rate movements with growth prospects and challenging period for emerging market currencies.inflation pressures. There is nothing like zero interest Exchange rates among the ZIRP nations will be drivenrate policies (ZIRP) from the major currencies to provide by the on/off political process instead of economicincentives for market participants to seek higher yields fundamentals. Exchange rate movements for emergingelsewhere, including emerging market currencies. The market currencies will respond to the ZIRP worldessential policy challenge for emerging market central differently, depending on how market participants shiftbanks is how to encourage economic growth in these their evaluation of the foreign exchange carry trade indifficult times without fueling inflation on the one hand light of the volatility box conundrum and the interest rateor creating an environment that would lead to too or foreign reserve management choices of the variousmuch currency appreciation that could weaken growth central banks.prospects on the other hand.This report first briefly discusses the context of ZIRP, I. ZIRP is here for an extended periodnamely why near-zero rates in the mature industrial The US Federal Reserve responded to the financial panicworld are encouraging global markets participants to of 2008 by moving to near-zero short-term interestreact to the on/off process of political decision making. rates and initiating the first round of quantitative easing.Second, we present our perspectives on the transfer The Fed has been in ZIRP mode ever since, even thoughof volatility to emerging market currencies, which we the economy started growing again in the third quartercall the “Volatility Box Conundrum.” Our Volatility Box of 2009 and has been moving forward steadily, if notapproach allows us to frame the issues facing emerging impressively, at around a 2% annual real GDP growthmarket central banks as they decide on various policy rate. Moreover, the unemployment rate, which peakedcourses which will impact their exchange rates. Next, at 10% has also declined to below 8%, yet the Federalwe apply our analysis to examine some key emerging Reserve has viewed the economy as so fragile as tomarket countries to see where they fit into the Volatility require two additional rounds of quantitative easing asBox Conundrum. We discuss India and China as theyDisclaimer. The research views expressed herein are those of the author and do not necessarily represent the views ofthe CME Group or its affiliates. All examples in this report are hypothetical interpretations of situations and are usedfor explanation purposes only. This report and the information herein should not be considered investment advice orthe results of actual market experience.1 market insights
  2. 2. december 18, 2012well as a maturity extension program (i.e., Operation suggests ZIRP will be abandoned. If anything, the newTwist) to further encourage lower long-term Treasury BoE Governor will focus even more intently on issues ofbond yields. There is every indication that ZIRP will financial market regulation (Canada’s banking systemremain in place through 2014 and possibly longer came through the panic of 2008 in relatively good form,(although we doubt it), even if the fiscal cliff is resolved especially compared to the UK and the US). ZIRP isand US economic growth continues at the 2% pace or likely to be continued and may be accompanied by moreeven better. quantitative easing to mitigate the pain for difficult UK banking system reforms.The European Central Bank (ECB) made it clear back inSeptember 2012, that they would do whatever it takes While there are a myriad of consequences andto preserve the single currency. From our perspective, implications related to all of the major industrial country“whatever it takes” implies an extended period of central banks being in ZIRP mode for an extended periodextremely low short-term interest rates for the Euro. of time, we want to focus on two that have profoundThe need for austerity programs all across Europe is not implications for how currency markets trade. First, theregoing away. In general, most European banks remain is the market focus on the political decision process insidein need of more capital and are not ready for Basel III, the major countries of the US, Europe, UK, and Japan. Thisdespite rhetoric to the contrary. The combination of political focus encourages “risk on/off” market behavior.fiscal austerity and a weakened banking system strongly Second, there is the challenge of evaluating the currencysuggests continued stagnation in northern Europe and implications of emerging market monetary policies whenrecession in the more deeply indebted countries. Our the major currencies are in ZIRP mode.projection is that the ECB will remain in ZIRP mode foryears to come. A. xchange rates among the majors follow E politics, not fundamentalsThe Bank of Japan (BoJ) was the inventor of ZIRP, back in1995. When Japan’s stock and property market bubble of When the central banks of all the major countries arethe 1980s finally burst – or was punctured by rising rates in ZIRP mode, then the lack of differentiation in interestfrom the BoJ – there was a period of denial. Japanese rate policy shifts the attention of the currency marketspolicy makers anticipated getting back to normal sooner to political decisions. In the US, the question is how torather than later. As the economy struggled and the resolve the fiscal cliff. In Europe, the challenges surroundJapanese yen continued to strengthen in the early 1990s, how to bailout over-indebted countries and fix thethe BoJ responded with the introduction of a zero-rate weakened banking system at the same time. In Japan,policy, and the BoJ has been in ZIRP mode ever since. the political issue is whether to actively weaken the yenCurrently, election politics in Japan strongly indicate in an attempt to create some modest inflation pressurethat ZIRP in the future may even be accompanied by and relieve the perceived negative drag on the economyadditional quantitative easing in the form of purchases from persistent deflationary expectations. In the UK,either of domestic government debt or of US Treasuries where fiscal austerity was practiced more aggressively atas part of foreign exchange intervention to encourage a an earlier stage, the political decisions involve the timingweaker yen (versus the US dollar). of when more pro-growth policies might be enacted or brought forward.The United Kingdom recently took the unusual stepof appointing a Canadian to run the Bank of England If only one major country was in ZIRP mode and all the(BoE). While this was a novel move and will undoubtedly others were following normal monetary policy pathsshakeup the power establishment inside the BoE, based on inflation and economic growth data, then FXthere is nothing in the transition from former Governor analysis would be considerably more straightforward. TheMervin King to incoming Governor Mark Carney that single ZIRP country could be treated as a special case,2 market insights
  3. 3. december 18, 2012such as Japan from 1995 until the other majors adopted decisions of the emerging market countries. The oldZIRP in 2008. In such a case, there would be discernible rules of thumb may no longer apply, and here is why.signals from relative monetary policy among the countries Before the financial crisis in the mature industrialto assist in FX analysis; fundamentals would matter, and countries in 2008 and before the ZIRP post-crisis period,trends often persist.When all four major countries have there was a reasonable ability to use similar analyticsadopted ZIRP and appear likely to maintain ZIRP for for both the major industrial countries and emergingyears to come, then there is no FX signal at all in relative market countries to attack the question of whichshort-term interest rate differentials. In effect, currency countries had more accommodative or more restrictivemarket participants have to look elsewhere to understand monetary policies than other countries. More or less,why one of the major currencies might outperform there was a level analytical playing field. While differentanother. This takes the analysis into the political realm, fundamental analysts might prefer different metrics,and it emphasizes the on/off or binary nature of political in general, a country whose central bank maintained adecisions. Fundamentals are less important, and incipient positive premium of short-term rates over the prevailingtrends have a way of reversing abruptly. inflation rate was deemed to be focused on controllingThink about the reality of the situation from the inflationary pressures. Other indicators would include theperspective of a currency market participant. Essentially, shape of the yield curve, with a more positive slope fromthe US dollar, euro, Japanese yen, and British pound short-term rates to long-term bond yields suggesting aare all “sick” currencies. To favor one over the other, one more accommodative policy. And in the case of thosehas to decide if a currency just has the flu or if another countries known to manage their currencies, a moreis in the intensive care ward. The analytical process is rapid pace of accumulation of international reserves wasinherently a political one based on one’s perceptions of a useful indicator of relative monetary policy ease.whether long-term political compromises to address the We are not suggesting these critical metrics be throwneconomic challenges are likely to be made versus the out the window. We are just implying that in a ZIRP worldmore common course of kicking the can down the road we need to add some caveats and nuances that couldand delaying meaningful action. The implication of ZIRP mean all the difference in the interpretation.in all the major countries encourages markets to tradein a “risk on/off” fashion influenced heavily by the messy The essential problem for FX analysts is that since allnature of political decision making. the major industrial countries have near-zero rates plus varying degrees of quantitative easing, they are all inB. Absolute rules of thumb to evaluate emergency, accommodative mode using some non- monetary policies no longer work standard techniques for the conduct of monetary policy. By contrast, in the emerging market world, central banksOne must always remember that the nature of any are still using only two traditional tools – short-termexchange rate is that it is a relative price of one currency interest rates and/or purchases/sales of foreign reservein terms of another. Thus, FX analysis is all about relative assets (usually US Treasury securities). As will be appliedcomparisons. There are no absolutes in the FX world. in the next section on the Volatility Box Conundrum, theZIRP makes this observation all the more important. old rule of thumb for monetary policy evaluation using theZIRP among the major countries removes relative premium of the short-term rate over the prevailing inflationmonetary policy from the FX analysis in terms of the rate may yield incorrect conclusions in the ZIRP world.interplay of the US dollar, Euro, Japanese yen, and British What matters in the ZIRP environment is the relativepound, as discussed above. What is less well appreciated degree of accommodation in emerging market countriesis that ZIRP among the major countries changes the way compared to the major ZIRP countries. This means, asFX analysts should be looking at the monetary policy3 market insights
  4. 4. december 18, 2012a hypothetical example, even if an emerging market Figure 1. Volatility Boxcountry reduced its short-term rate to be equal to its Emergingprevailing rate of inflation, in a “risk-on” context, it might Market Country US Federalhave an attractive currency due to the rate differential. Short-tern Funds Rate Interest RateBy contrast, current market practitioners operatingaccording to the pre-ZIRP interpretation would have put Joint Interest Ratethis emerging market country in the “easy money” camp Exchange Rateand possibly sold it. With all the major countries in ZIRP Market Volatilitymode, the new interpretation is that a small negativerate premium to current inflation may still represent Spot FX/ Futures FX/a considerably and relatively tighter monetary policy USD Rate USD Ratethan in the ZIRP countries. Put another way, ZIRP inthe major countries has the potential to encourageemerging market countries to lower their own rates. Now think through the policy choices of the emergingSo, even if an emerging market country lowers rates, market country’s central bank. If the emerging marketthereby reducing the rate premium over inflation, or even central bank decides to control its own short-termtakes short-term rates below the rate of inflation – it interest rate (upper left), then this fixes the interestmay still have the potential for currency appreciation rate differential and sets the FX futures premium (lowerversus the major ZIRP currencies, especially if market right), given ZIRP in the US (upper right). Thus, byparticipants decide it is time for “risk-on” trades. choosing to set its own short-term interest rate, the only place where global market forces that causeII. olatility Box Conundrum for emerging V FX volatility can be reflected is in spot FX. The logic market countries works similarly when a country chooses to stabilize its exchange rate. That is, if the emerging market centralThe Volatility Box Conundrum is a direct consequence bank prefers to manage its exchange rate, thenof applying ZIRP assumptions to FX interest rate parity market forces causing FX volatility will be reflectedtheory. The ideas are intuitive and straightforward, but in the short-term interest rate or in related assetnot often fully appreciated. activity on the central bank’s balance sheet.Consider a box with four corners. The lower left corner What is often implicit, but needs to be appreciated,is the spot FX rate between an emerging market country is that for the most part the emerging market centraland the US dollar (representing the major currency bank has to deal with global market forces impacting itsZIRP regime). The upper left corner is the prevailing currency. The most that the central bank can do isshort-term interest rate in the emerging market country, choose the channel taken by this external volatility;and the upper right corner is the prevailing short-term the volatility itself cannot be reduced or eliminated.interest rate – effectively zero – in the US. The lower right That is, the emerging market central bank can opt forcorner is the FX futures premium relative to the FX spot policies that enhance exchange rate stability, but thisrate (lower left). Using interest rate parity theory the FX comes at a price of (1) more short-term interest ratefutures premium equals the market short-term interest volatility or (2) more central bank asset volatility in therate differential for the maturity of the futures contract. form or foreign reserve accumulation (or depletion in the currency weakness case). Or the emerging market central bank can take the alternative approach and fix its short-term interest rate, accepting the consequences in terms of heightened exchange rate volatility.4 market insights
  5. 5. december 18, 2012The Volatility Box Conundrum for emerging central banks, Before analyzing specific countries, let take a lookgiven ZIRP in the major currencies, is that they cannot at some comparative data that highlight the choicereduce the amount of externally generated market of exchange rate stability. We want to compare thevolatility; all they can do is channel the volatility either into annualized standard deviation of monthly exchangetheir currency or into their interest rates (or central bank rate percent changes with the accumulation of foreignasset purchases). In more normal times, this was not an reserves. Foreign reserves are often divided intoeasy policy choice even when the major country central securities and gold, and because different countriesbanks were running their monetary policies to reflect a value their gold holdings differently, we present our datasmall premium in their rates over inflation. Now, when the in terms of the US dollar value of international reservesmajor countries are all in ZIRP mode and running highly minus gold and then we show the millions of ounces ofaccommodative monetary policies, the complexities of gold held separately.central bank policy-making for emerging market countriesare made incredibly more difficult. A. Foreign Reserves and Mitigating Currency VolatilityIII. FX implications for selected emerging Countries that choose the path of dampening exchange market countries rate stability will tend to accumulate foreign reservesEmerging market countries have their own domestic when there is upward pressure on their currency. Thatpriorities that are likely to drive their FX policy choices. To is, they purchase foreign assets, often US Treasuryunderstand better the choice sets and how to interpret securities, paying for the purchase with their ownpossible FX scenarios, we suggest dividing emerging currency, thereby increasing its supply to the FXmarket countries into two categories. The first category markets. This puts downward pressure on the country’sconsists of those countries that have extensive exchange short-term interest rates in theory. But in practice not allrate or capital controls, even though they may (or may emerging market countries have liquid money markets,not) be on a path toward currency normalization – for so this pressure may be masked. Note that sterilized FXexample, India, China, and Russia. The second category intervention means that foreign reserve purchases byinvolves countries with less onerous capital controls, the central bank are offset by domestic government debteven if some exist, as well as reasonably well developed sales, and the net result usually means no long-termand liquid short-term money markets – for example, impact on the currency. Only unsterilized FX interventionBrazil and Mexico. Despite dividing countries into these works long-term to mitigate currency instability.two generic categories, we have to emphasize that everycountry chooses its own path, and the exchange rateoutcomes will all be different.5 market insights
  6. 6. december 18, 2012Table 1. Gold and Foreign Reserves (October 2012) International Reserve Standard Deviation Holdings Minus Annualized of FX/USD Gold in US Dollars Gold in Million Ounces, Monthly Percent Change (Billions, IMF Basis) IMF Basis Since Jan-2010 Major ZIRP Countries United States $50 261 NA Euro-Zone $217 347 12.44% United Kingdom $58 10 8.84% Japan $800 25 8.98% Selected Emerging Market Countries India $175 18 10.88% China $2,143 34 1.90% Russia $308 30 14.29% Brazil $243 2 16.70% Mexico $104 4 13.84% Source: Bloomberg Professional and CME Economics Calculations.China is the country that has most aggressively chosen Japan’s large (US$ 800 billion) holding of foreignto mitigate currency market volatility. Even with a reserves is indicative of the extent that the Bank of Japansliding peg to allow for some currency appreciation, the has used this version of quantitative easing (namely,annualized standard deviation of the monthly percentage purchasing US Treasury securities) to keep the yen fromchange in the RMB/USD exchange rate has been less rising more than it otherwise would have, even afterthan 2% since 2010. Volatility of over 10% is more the decades of ZIRP.norm. To achieve this low degree of volatility, Chinahas amassed several trillion US dollars of international B. Interest Rate Choicesreserves. The other central bank choice highlighted in our analysisAlthough the international reserve holdings of Brazil, is the level at which to set short-term rates relative toIndia, Mexico, and Russia may appear small in domestic inflation. With the exception of Japan, all thecomparison to China, any accumulation by a given major ZIRP countries have negative inflation adjustedcentral bank of foreign reserves of more than US$100 short-term interest rates. Japan shows a small positivemillion is a clear sign of at least of some effort to mitigate because it has a slight touch of deflation.currency volatility and specifically to lean against thewind of currency appreciation.6 market insights
  7. 7. december 18, 2012Table 2. Current Short-Term Rates and Inflation (Q4/2012) Current Real Short-Term Policy Rate Inflation Rate (Inflation-Adjusted) Rate Major ZIRP Countries United States 0.16% 2.18% -2.02% Euro-Zone 0.06% 2.24% -2.18% United Kingdom 0.50% 3.19% -2.70% Japan 0.13% -0.30% 0.43% Selected Emerging Market Countries India 8.09% 9.60% -1.51% China 3.00% 2.00% 1.00% Russia 8.25% 6.50% 1.75% Brazil 7.14% 5.53% 1.61% Mexico 4.85% 4.18% 0.67% Source: Bloomberg Professional and CME Economics Calculations.Current real or inflation adjusted short-term interest Box perspective, India has typically chosen to controlrates are positive for China, Russia, Brazil, and Mexico. All its short-term interest rate so as to manage inflationof these countries have narrowed their rate differentials expectations, while allowing the Indian rupee to absorbto inflation in the past few years. India has an elevated the volatility. This has been on display recently, as theinflation rate (above 9%), and has chosen not to keep Indian rupee has declined in value relative to the USrates above 10% to maintain a positive premium over dollar due to concerns over India’s policy toward foreigninflation. investment as well as rising inflation pressures. Figure 2.C. merging market countries with E extensive capital controls, less developed property rights, or banking system limitationsIndia. Let’s start our country-by-country analysis withIndia. It is a relatively insular country. Its capital controlpolicies emphasize a desire to maintain local controlof foreign investment where possible. Also, domesticentities face a myriad of rules and restrictions whentrying to move money outside the country. WhileIndia appears to have amazing long-term potential,many observers see its heavy-handed bureaucracy,capital restrictions, and currency controls as being adrag on economic growth while making the control of If and when India makes the political choice to reducedomestic inflation extremely hard. From a Volatility currency and capital controls, some observers would see7 market insights
  8. 8. december 18, 2012a chance for greater FX volatility in the rupee. We would noted previously. That is, the volatility from worldnot, however, agree with this assessment. Our perspective markets as they interacted with the Chinese economyof international markets is that countries that choose was reflected in the tremendous growth of China’sto let money flow freely often find that money comes foreign reserve holdings.into the country – since it is free to leave. And for those If and when China decides to ease its currency controlscountries that restrict money from leaving the country, and to normalize exchange rate transactions, Chinawell, individuals and corporations often successfully find will have to reconsider how it manages its monetaryways to get their money out of the country. policy. Currency normalization, however, will not occurFor India, we would argue that more currency freedom in a vacuum. The nature of tradable currencies is thateasily might lead to increased inflows of foreign capital, their future values, compared to the spot exchange rate,given the huge long-run economic potential of the incorporate a premium (or discount) for interest ratecountry. In this case, India’s central bank might find it differentials. This means that active trading in currencies,acceptable to reduce short-term interest rates, given including futures and forward transactions, comes handthat the potential capital inflows might create a rising in hand with more liquid short-term money markets.currency which would assist with inflation control. In any If China accelerates its progress toward currencycase, however, we would expect India to continue to use normalization, as we think the new leadership willits short-term money market interest rate as the primary do, then increasing the pace of money markettool for monetary policy, allowing the exchange rate to development and encouraging a more matureadjust accordingly and absorb market volatility. banking system are an integral part of the process.Currently, our view is that India’s inflation rate will soon To the extent that China can create a financial systemdecline, due to demand weakness domestically and that can support a liquid money market, it will also createglobally. Also, the weakness of the currency in 2011- for itself more options in how to manage its monetary2012 was in part caused by home-grown issues related policy. China will still have to make choices from withinto the treatment of foreign investment. India is moving the Volatility Box, but it may choose to back away fromto address these issues, and there are some signs of currency stability, stopping or reducing its purchases ofincreased capital inflows and a modest rebound in US Treasuries as part of that process, and move towardthe currency. short-term interest rate management as the primary tool of monetary policy. This is, perhaps, a long time into theChina. China has chosen a different currency path. future, but a more open currency arrangement increasesChina has even more extensive capital and currency domestic policy options, although at some cost in termscontrols than India. Over the last several decades, of increased currency volatility. Given China’s currentChina has used its state-run enterprise system stage of economic maturity, and its desire to moveto channel huge infrastructure spending into the away from an infrastructure-driven economic growthdomestic economy to propel its economic growth, while model and move toward a domestic-demand model, therestricting the inflow of foreign capital. At the same combination of currency normalization and a faster pacetime, to encourage exports and manufacturing growth, of development for the financial system, including theChina opted for the path of currency stability via tight encouragement of more liquid money markets, all makescontrols on the renminbi (RMB). perfectly good policy sense.Without a well-developed banking system and liquid Russia. Russia joins China and India in the “capitalmoney market, the choice of currency stability was controls” category of currency analysis, becauseaffected not by interest rate policy, but by the purchase property rights are not always as clear as some wouldof foreign assets, such as US Treasury securities as hope, there are many controls and regulations that8 market insights
  9. 9. december 18, 2012hinder foreign investment, and money markets are not straightforward, while the policy decisions facing thewell developed. Russia is different yet again from China central bank are every bit as difficult.and India, however, in terms of how it makes its currency In the 1970s and 1980s, Brazil was known for itsmanagement choices. hyper-inflation. In the late 1990s and early 2000s, aRussia’s government depends critically on revenues from concerted effort was made by the central bank to deliveroil and gas, and the economy is more or less managed on a promise of controlling inflation, by maintainingwith this in mind. Without a diversified manufacturing short-term interest rates at a steady premium abovebase, developments in the energy markets, along the inflation rate. The result was both improved inflationwith the ebb and flow of the political environment are control and an appreciating currency. The perceptionimportant currency drivers. In times when global market among some policy makers that the Brazilian real wasparticipants are attracted to Russia’s energy resources, appreciating too rapidly and potentially harming theRussia can opt for currency stability and resist currency domestic economy led to the imposition of certain taxesappreciation by purchasing foreign assets such as US and rules to control capital flows.Treasury securities. When domestic political tensions The financial panic of 2008, however, changed the game.cause global market participants to withdraw, or when In a ZIRP world, with Brazil’s large short-term interestenergy markets turn downward, Russia can choose to rate differential versus the US and other major countries,spend its foreign reserves to prop up the currency or the Brazilian real tends to feel pressure for appreciationsimply allow the currency volatility. On net, as seen earlier, only when there is a global “risk-on” environment, andRussia has been an accumulator of foreign reserves, the currency trend abruptly turns to depreciation whenindicating some desire to mitigate currency volatility. market participants shift to “risk-off” The “risk on/off” .Essentially, there is an asymmetry to Russia’s choice switch is totally out of the control of the Brazilianset within the Volatility Box. This occurs in part because authorities, as it is mostly driven by the politicalRussia’s own political environment generates considerable decision process of the major ZIRP countries. If anyvolatility in addition to the volatility from global sources country is subject to the Volatility Box Conundrum, itand partly from the one-dimensional nature of the is Brazil.economy. Thus, if and when market forces lead to In the post-2008 ZIRP world, Brazil has chosen a mixedcurrency depreciation, Russia may be reluctant to spend approach. When global markets shift to “risk-off” Brazil ,its foreign reserves, choosing currency depreciation and has allowed currency depreciation while more or lessits accompanying volatility instead. When energy markets allowing the increased volatility to hit the currency andare strong and provide an upward lift to the currency, not domestic short-term interest rates. In those periodsRussia can choose to balance the accumulation of foreign when global markets have shifted to “risk-on” the,reserves with a desire for more currency stability – that is, currency has moved higher, but the authorities typicallyleaning against the winds of appreciation. have (1) opted for more foreign reserve purchases to slow the rise of the currency and (2) have moved to lowerB. merging market countries with more E interest rates, effectively also narrowing the premium open banking systems and liquid short- over the prevailing inflation rate. term interest rate markets Should the US get by its fiscal cliff, and the ECB containBrazil. While Brazil has occasionally adopted transaction the financial damage to the Euro, then a more prolongedtaxes and other means of limiting currency movements, “risk-on” environment will test Brazil’s policy mix. InBrazil has a much more open and market-driven financial particular, our Volatility Box analysis suggest, given a “risk-system than the countries we have put in the “capital on” environment in a ZIRP world, that Brazil may have tocontrols” category. This makes the analysis more9 market insights
  10. 10. december 18, 2012choose between a strengthening currency (that is, moving IV. Synthesisbelow 2.00 BRL per USD) or making further cuts in We can summarize the challenges that the Volatilityshort-term interest rates that would virtually eliminate the Box Conundrum poses for emerging market economiespremium over inflation. In this hypothetical scenario, we as follows:might see all of the above – that is, currency appreciation,rate cuts, and foreign reserve accumulation. When global markets are in “risk-off” mode, ZIRP does not matter, and emerging market currencies tendMexico. Mexico shares a long border with the US and to depreciate. For the most part, emerging marketits economy is much more intertwined with its neighbor countries tend to accept the volatility and currencyto the north than any of the other economies we have weakness during the “risk-off” environments, given thatconsidered here. The higher degree of US-dependence they cannot control it anyway.does not change the analytical framework, but itdoes magnify the impact on the path and volatility of When global markets are in “risk-on” mode, ZIRPthe currency. Even more than Brazil, Mexico is in the makes things a lot more complicated, not to mentioncrosshairs of the Volatility Box, or in terms of the FX interesting, for currency market participants, because itmarkets, a very attractive FX carry trade during “risk- accentuates the policy choices framed by the Volatilityon” market environments. The ZIRP world, moreover, Box. Emerging market currencies generally belong tohas allowed Mexico to have lower short-term interest the class of financial exposures considered as high risk.rates with a narrower premium to inflation than would In “risk-on” environments, market participants are byotherwise have been consistent with reducing inflation. definition drawn to risker exposures to enhance their expected returns.What this means for Mexico, and what one can see inthe movements of the currency relative to the US dollar, In a “risk-on” ZIRP world, countries with well-developedis that the Mexican peso is currently trading US political money markets and relatively open currency marketsdevelopments. That is, knowing whether one is in “risk- may choose to lower short-term interest rates, andon” (US fiscal cliff resolved) or “risk-off” (US heading narrow or eliminate the premium over the inflationfor the cliff with no fiscal compromise in sight) is driving rate rather than ramp up their accumulation of foreigncurrency volatility. reserves to what may be perceived as excessive amounts. Brazil and Mexico fit into this category.Figure 3. While India has tight currency controls, and even though it has a more severe inflation challenge than Brazil or Mexico, India may also consider lowering interest rates as a counter to a strong currency, if (a big if) such a trend develops in a “risk-on” environment during 2013. Until China can achieve normalization of its currency movements, it is likely to prefer currency stability, since it does not have sufficiently well-developed money markets to use lower interest rates as a counterweight to currency appreciation. This means in a “risk-on” environment, China may resume its accumulation of US Treasury securities and other foreign reserves. If deeper and more liquid money markets can be developed, then currency normalization can be accelerated and China can move more toward interest rate management and away from reserve accumulation.10 market insights
  11. 11. december 18, 2012Russia feels a double-impact from “risk-on” participants are in a “risk-on” or “risk-off” mode.environments. “Risk-on” also may come with higher More than anything else, this determination of “risk-energy prices, so the currency volatility and upward on” or “risk-off” is more likely made due to politicalpressure may be increased. Interest rate policy is only considerations in the major industrial countries as theypartly effective, and domestic politics and property deal with the challenges of their excessive debt.rights developments play a large role. Thus, currency The implication for emerging market countries ismovements in Russia are more multi-faceted and more that their currencies may depreciate and experiencecomplex to analyze than the simplified Volatility Box increased volatility through no fault of their own andapproach used here, although the pressures are still the with little ability to do much about it. When markets shiftsame direction. to “risk-on” however, our perspective is that emerging ,Finally, we emphasize that the analysis of emerging market countries then face the challenge of potentialmarket currencies in a ZIRP world starts with the currency appreciation and are constrained by theassessment of whether global financial market Volatility Box in terms of their policy choices.Learn more about our NEW physically delivered Chinese Renminbi contracts (USD/CNH) andour NEW cash-settled Indian Rupee contracts (INR/USD) by visitingcmegroup.com/rmb and cmegroup.com/inrReceive email updates when new reports are released by subscribing to the Market InsightUpdate at cmegroup.com/subscribe.CME Group is a trademark of CME Group Inc. The Globe Logo, CME, Chicago Mercantile Exchange and Globex are trademarks of Chicago Mercantile.Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. New York Mercantile Exchange and NYMEX areregistered trademarks of the New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc.The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions.Although every attempt has been made to ensure the accuracy of the information within this brochure. Additionally, all examples in this brochure are hypotheticalsituations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.Citation: Please reference as “China: Slower Export Growth, End of the Infrastructure Boom Years” Bluford H. Putnam, CME Group Market Insights Series,December 2011, cmegroup.com/marketinsightsCopyright © 2012 CME Group. All rights reserved.11 market insights