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How hard has COVID-19 hit EM currencies?

Ron Leven
Ron Leven
Professor of Economics at Duke University

June’s Market Voice analyzes the prospects for Emerging Market (EM) currencies weakened by COVID-19, and asks which of the currencies offer the best potential for attractive carry should markets stabilize.


  1. COVID-19’s impact on the global economy has been severe, and more so for Emerging Markets, which have been affected by broad currency weakness.
  2. Several EM currencies are now significantly undervalued, with the TRY offering relatively good carry. However, carry is broadly depressed across Emerging Markets because of creeping global deflation.
  3. The volatility and uncertainty in market conditions are causing a modest widening of bid/ask spreads. However, volume on the Refinitiv foreign exchange platforms remains robust.

The economic adjustment to the post-COVID-19 environment for the United States and other developed countries has been profoundly difficult. However, the Emerging Markets (EM) are facing even more dire circumstances.

Weaker infrastructure is compromising their ability to contain the virus. Many of these countries have export driven-growth, and are therefore particularly vulnerable to the slowdown in global growth. This is particularly so for commodity dependent economies that are seeing a collapse in their terms of trade as export prices sink.

Meanwhile, a heavy overhang of external — mostly USD — debt by both sovereign and commercial borrowers creates risk of defaults and insolvencies as weaker currencies inflate the local servicing cost of this debt.

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Which EM currencies have weakened most?

Consistent with the increased vulnerability to COVID-19, EM currencies have generally weakened this year against the USD, but as shown in the left panel of Figure 1, the weakness has been far from uniform.

Most of the major EM currencies as shown have weakened 2-5 percent since the start of the year, but there are a few positive standouts — PHP, TWD and KRW — which have held up much better than the crowd. However, outliers to the downside have been more extreme.

The chart highlights the five negative outliers that are led by the 30 percent depreciation of the BRL. All five of these currencies have weakened more than 10 percent.

There is a possibility that these five currencies — BRL, ZAR, MXN, TRY, COP — are overshooting, and poised to bounce back if global economic conditions stabilize. However, this would only be likely if the sharp declines put the currency in fundamentally undervalued territory.

The panel on the right of Figure 1 shows how the current broad trade-weighted currency stands in real terms versus the average valuation over the past 10 years.

Figure 1: Emerging market currency performance in the time of Covid-19

Figure 1: Emerging market currency performance in the time of Covid-19.How hard has COVID-19 hit EM currencies?

BRL, again, is a standout at over a 20 percent undervaluation from the 10-year average. The currencies in the major-decliners category are all in the group of significantly undervalued — mostly at almost 20 percent below average — so they all appear to have potential for substantial bounce-back.

Where is my attractive carry?

Attractive carry is also a common motivation for investing in EM currencies. Figure 2 utilizes the Eikon Currency Performance/Value Tracker to help determine whether any of the above exceptionally weak currencies also offer relatively high yields.

Figure 2: Most attractive emerging market vs USD 1Y rate spread

Most attractive emerging market vs USD 1Y rate spreads. How hard has COVID-19 hit EM currencies?
Notes on Figure 2: Bright red is upper 10th percentile and dark red upper 25th percentile. Bright blue is bottom 10th percentile and dark blue bottom 25th percentile. The percentiles of the absolute carry are across all available currency pairs. Percentile values are based on the prior three-year history of that interest rate. Source: Eikon

An indication of creeping global deflation is that even under conditions of broad currency weakness and crashing economic activity, only two EM 1Y currency forwards offer net carry versus USD above 5 percent.

And only one currency, TRY, offers the kind of double-digit yields that were common during the last decade.

TRY aside, MXN is the only other significantly undervalued currency offering relatively attractive yield compared with what is currently available across the entire currency space (the maximum-weak BRL offers only 1.34 percent net carry).

However, as shown in the second column, the MXN 4.61 percent current 1Y spread is extremely low by historical standards. Only 1 percent of the days over the past three years has seen a rate lower than this.

In contrast, the TRY net carry is roughly in line with the average for the past three years, and this comparison is probably distorted downwards by creeping global deflation. The third column in the table is the three-year percentile for net carry adjusted for risk by scaling the rate by one-year implied currency volatility.

On this basis, TRY looks less attractive because risk-adjusted carry is only in the 31st percentile. This is well below average. But as with the percentile for the outright carry, we suspect the comparison with history is being distorted by the deflation-generated low global rate environment.

Figure 3 shows the close historical tracking between one-year Turkish interest rates and implied volatility.

This is not surprising. Periods of sharp currency weakness typically put upward pressure on both yields and volatility. It is apparent that the rise in rates has lagged volatility, which is likely reflective of the downward drag on interest rates across the global economy.

Note that Indonesian rates arguably are also attractive relative to other EM currencies. However referring to Figure 1, the IDR is one of the most overvalued currencies in the world, and so has potential for further weakness.

Figure 3: One-year Turkish deposit rate and TRY implied volatility

One-year Turkish deposit rate and TRY implied volatility. How hard has COVID-19 hit EM currencies?

It’s not only about COVID-19

Figure 4 taken from the TRY Eikon Chartpack shows that TRY weakness emerged in the middle of last year, long before the COVID-19 crisis.

The decline reflects domestic and regional challenges in Turkey, primarily related to the power politics of President Erdoğan, and which included an increased fiscal deficit and the erosion of central bank independence.

TRY weakness also reflected the regional turmoil that was related to the military activity in Syria and the decline in oil prices.

The chart includes the Turkish five-year credit default swap (CDS) which has generally been linked to TRY performance and can serve as a proxy for politically associated risks in Turkey.

The spread has narrowed sharply in recent weeks, which is a supportive indicator for the TRY. That said, in 2019 the spread narrowed substantially without significant TRY strength. However, the advantage of high carry is that holding TRY is attractive as long as the currency remains stable.

Figure 4: TRY and the five-year Turkish sovereign credit default swap (CDS)

TRY and the 5-year Turkish sovereign credit default swap (CDS)

Illiquidity and EM currencies

Illiquidity is another problem that creates a challenge to positioning in EM currencies.

Refinitiv has focused on increasing the volume of trading on its currency platforms. This has significantly improved access to these currencies, even in times of high volatility.

Figure 5 shows that the volume of trading for the TRY on the Refinitiv FX Matching platform has remained robust even during the highly volatile period in early March when the dangers of COVID-19 became apparent.

Bid/ask spreads widened, but this is to be expected when market volatility spikes higher and, in any event, spreads now appear to be normalizing, especially for smaller trade size.

For comparison, Figure 6 shows the same information for the MXN, which is the other currency that is potentially attractive from both a valuation and carry perspective.

Here, too, the volume of trading remains robust. However, the normalization of spreads is lagging.

Figure 5: Volume and bid/ask spread for TRY

Volume and bid/ask spread for TRY TOM

Figure 6: Volume and bid/ask spread for MXN

Volume and bid/ask spread for MXN

Broad weakening of EM currencies

In conclusion, as hard as the adaption to COVID-19 has been for the United States, the negative impact on EM economies has been even more severe, and this is reflected in broad weakening of EM currencies against the USD.

Evidence shows that several of the weakest EM currencies — BRL, ZAR, TRY and MXN — are now significantly undervalued in real terms. This creates the potential for a sharp recovery if global markets stabilize.

Of these, the MXN and, especially, TRY, also offer relatively attractive carry.

While a highly volatile environment may keep bid/ask spreads higher than normal, trading volume on the Refinitiv platforms remains robust.

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