Emerging Markets: What has Changed

(from my colleague, Dr. Win Thin)

1) China’s FX regulatory body, SAFE, announced additional reforms to its currency trading rules

2) The HKMA acted to defend the HKD peg for the first time since December 2012

3) The won continues to strength despite more North Korea threats and official pushback BOK

4) The news out of South Africa remains bad on the labor front

5) Violence is escalating again in Ukraine as the cease-fire breaks down

6) Argentina has missed a payment on restructured bonds coming due Monday June 30

Over the last week, Argentina (+4.3%), India (+3.0%), and Russia (+2.7%) have outperformed in the EM equity space in local currency terms, while Turkey (-1.8%), Poland (-1.6%), and Czech Republic (-1.3%) have underperformed. To put this in better context, MSCI EM was +1.1% over the past week.

In the EM local currency bond space, Sri Lanka (10-year yield -32 bp), Indonesia (-15 bp), and Korea (-10 bp) have outperformed over the last week, while Brazil (10-year yield +23 bp), Mexico (+15 bp), and Hungary (+14 bp) have underperformed. To put this in better context, the 10-year UST yield was +14 bp over the past week.

In the EM FX space, IDR (+1.5% vs. USD), COP (+1.4%), and KRW (+0.8%) have outperformed over the last week, while RUB (-1.9% vs. USD), ZAR (-1.6%), and BRL (-1.6%) have underperformed.

1) China’s FX regulatory body, SAFE, announced additional reforms to its currency trading rules. The new rules will allow commercial banks to set their own rates for non-bank clients (such as retail), instead of having to follow a set of pre-established directive. This should not change anything regarding the CNY fixing.

2) The HKMA acted to defend the HKD peg for the first time since December 2012. With USD/HKD pushing against the strong end of the 7.75-7.85 band, the HKMA bought a total $2.1 bln this week while noting that "Demand for the Hong Kong dollar increased lately," driven by "commercial activities, including merger and acquisition activities and dividend distribution." Defending the strong end is no problem, as the HKMA has a limitless supply of HKD to sell. For now, we see the HKD peg remaining in place for the foreseeable future.

3) Fresh military tests by North Korea (short-range missiles), dovish BOK minutes, and a joint statement by the Finance Ministry and the central bank were not enough prevent the won from reaching a 6-year high. The BOK took up a more dovish tone in its minutes, suggesting that inflation pressures are subdued and not likely to approach the 2.5-3.5% target range. Meanwhile, a joint text message by the Finance Minister and the BOK has stepped up verbal intervention, noting that authorities are closely monitoring offshore FX transactions and that movements may be “excessive.” We have long warned that a firm break below the 1020 level would trigger this reaction. Despite the continued positive flows and fundamentals, we do not think the risk-reward is there to stay short USD/KRW. That said, this that does not mean we are negative local assets, and still think there could be some opportunities in local fixed income instruments and especially equities, which have lagged many of its regional peers so far this year.

4) The news out of South Africa remains bad on the labor front. Just as the 5-month old platinum workers strike ended, the nation’s metalworkers union has started a strike that has perhaps wider-reaching impact on the economy. Construction at two Eskom power plants has been affected by the new strike, which in turn will hurt the nation's much-needed efforts to expand energy generation. The poor economic backdrop will very likely prevent any SARB tightening this year. ZAR is likely to continue under-performing.

5) Violence is escalating again in Ukraine as the cease-fire breaks down. Ukrainian President Poroshenko suspended the 10-day old ceasefire and resumed the military campaign against separatist rebels. Poroshenko said that the rebels had violated the cease-fire, killing and wounding many Ukrainian soldiers. The EU threatened deeper sanctions on Russia if it didn’t do more to rein in the separatists, but President Putin has so far remained defiant. Sanctions after the July 16 EU summit are possible if violence continues.

6) Argentina has missed a payment on restructured bonds that was due June 30. It was planning to make this payment on restructured debt whilst still negotiating with the holdouts, as Argentina deposited $1 bln last week with its bond trustee. However, the US court blocked the trustee bank from making any bond payments and ordered that money returned to Argentina. There is a 30-day grace period on this payment, and we see no quick resolution. However, it doesn’t help that Argentina is wasting precious time with its antics, including taking out a full page NYT ad. Argentine officials will first meet with a court-appointed mediator on July 7. We continue to believe that a default event here will not have a wider-ranging impact on EM.