Emerging Market FX Liquidity: Ready to Evaporate?

Over the past year, the liquidity in emerging currencies grew in fits and starts quarter to quarter. How do the next 12 months look?

Over the past three years, the global foreign exchange market has witnessed dramatic growth in liquidity in a number of leading emerging-market currencies, but is this a temporary anomaly or the new norm?

According to a recent article, FX and derivatives markets in emerging economies and the internationalization of their currencies, published by Torsten Ehlers, an economist at Bank of International Settlement (BIS), and Frank Packer, head of financial stability and markets for Asia and the Pacific at BIS, in the December 2013 BIS Quarterly Review, its been a heady time for three currencies. Turnover in the Chinese renminbi, Mexican peso and Brazilian real from 2010 to 2013 increased 249, 171 and 117 percent respectively.

And it has not gone unnoticed. Thomson Reuters platforms had record trading days in a number of its emerging-market currencies at various points throughout 2013, said James Kwiatkowski, global head of sales for FX at Thomson Reuters. Emerging-market currencies across the board have been affected; however, trading growth has been seen specifically in Eastern Europe, China and Latin America.

The latest BIS Triennial Bank Survey, published in September, listed the Chinese renminbi and Mexican peso as two of the 10 most traded currencies.

According to BIS numbers, turnover in the Mexican peso in 2013 reached $135 billion, which raised its share in global FX trading to 2.5 percent, Kwiatkowski said. The Russian ruble also saw a significant increase in market share, making it the 12th most actively traded currency worldwide, he said.

Ending a Tumultuous Year

Over the past 12 months, the liquidity in emerging currencies grew in fits and starts quarter to quarter, according to industry observers.

Saxo Bank experienced strong trading conditions in emerging-market currencies compared with previous quarters, according to a bank spokesman who declined to be named for this article. The trend continued until a second-quarter sell-off in May and June reduced liquidity; it rebounded in September, he told Traders.

Emerging-market trading liquidity becomes worse as volatility increases and vice versa, the Saxo Bank spokesman said.

However, the performance of these currencies did not occur in lockstep during the second half of 2013, said Blu Putnam, chief economist with global exchange-operator CME Group. Second-quarter depreciation was the norm, and quantitative easing talk from Federal Reserve chairman Ben Bernanke received most of the blame, he said.

Putnam sees the relative stability of the Mexican peso against the increased weakness of the Brazilian real and Indian rupee over the past year proving his point.

For trading 2013 year-to-date, the high-low range for the Mexican peso against the U.S. dollar has been 12 percent, which is just barely 1 percent higher than the range for the British pound and the Swiss franc against the dollar, he explained. By sharp contrast, there was a very wide range for the Brazilian real of 26 percent, and for the Indian rupee of almost 30 percent, as these currencies faced much more severe risks and difficulty with long-term challenges.

For Brazil, its government continues to focus on the growing the nations middle class, which has become an active force for improving government services, Putnam said. The middle-class protests have come during the infrastructure build for the World Cup and the 2016 Summer Olympics, and the currency markets reflect that considerable policy uncertainty. Its currency weakened to a break in the third quarter of 2013 and resumed the following quarter.

By contrast, India has highly restrictive capital controls and a growing current account deficit, which Putnam sees as part of the nations problem.

India is a big importer of gold, and they have raised taxes and tariffs to curb gold imports, he said. Perhaps more importantly, India provides huge subsidies for energy and food that further exacerbate the current account situation.Indias currency weakness, however, was arrested in the fourth quarter, in no small part due to a change of leadership at the central bank and a strongly signaled desire for financial and market reforms.

Driving Liquidity

Although many of the leading emerging economies strive to further grow their domestic economies and middle classes in a difficult zero-interest-rate environment, the cross-border demand for currency and its trading is not happening in the local or regional emerging markets.

Offshore trading of emerging-market economies currencies has surged, far outpacing the growth in total FX turnover in the emerging-market economies currencies, write Elhers and Packer. Among these currencies with the highest turnover growth are the Chinese renminbi, Mexican peso, Turkish lira and Russian ruble.

These institutional offshore traders, who look to rebalance their global portfolios and hedge their currency risk exposure, are driving the liquidity growth through the use of over-the-counter FX derivatives, which directly drives the liquidity in the underlying instruments.

According to their research, the turnover in over-the-counter FX derivatives in emerging markets grew from $380 billion in 2010 to $535 billion in 2013, or about 41 percent.

It doesnt hurt that the trading of the emerging-market currencies is facilitated by the use of electronic trading platforms that broaden the available trading community and let them reach critical mass, Kwiatkowski noted. The possible exception, however, is non-deliverable forward currencies where regulations have confused participants and dampened activity.

Given the strong performance of the U.S. stock market, despite QE taper talk, some asset allocation shifts away from emerging-market equities and currencies and into the U.S. and other mature industrial nations was only natural, CME Groups Putnam added.

The U.S. dollars role as the worlds dominate vehicle currency remains unchallenged, but other G10 currencies have not been as fortunate, Thomson Reuters Kwiatkowski said.

The euro remains the second most important currency worldwide, but its global market share decreased by 6 percent, to 33 percent, according to the BIS triennial survey, he said.

When compared to emerging-market currencies, the growth in trading volumes of developed-market currencies-but not including the U.S. dollar-was slower and weaker over the past year.

Kwiatkowski cites various reasons: appointment of a new governor to the Bank of England, continued fallout from the euro zone crisis (especially Cyprus and Greece), rating agencies downgrading various sovereign debt ratings, lower petroleum prices in the first half of 2013 and Chinese growth numbers not meeting market expectations.

All of these macro issues have an impact, he said. In June, emerging-market currencies, particularly the Mexican peso, suffered heavy losses in value after Fed chairman Bernanke laid out a timetable for the end of the U.S. bond-buying program, which led to higher interest rates in the U.S.

So long as short-term interest rate differentials among the U.S. dollar, British pound and euro are very close to zero, it is highly unlikely to see persistent trends, although plenty of volatility is likely due to swings in the political winds, agreed Putnam.

The Japanese yen is the only outlier of the G10 currencies, as the Bank of Japan, along with Prime Minister Shinzo Abes government, began an active promotion of a weaker yen-dubbed Abenomics-at the start of 2013.

The yen versus the U.S. dollar then stabilized until very recently, when some additional weakness has been observed. Its fate in 2014 will probably hang on how much additional stimulus Prime Minister Abe and the Bank of Japan provide to counter the depressing effects of the national sales tax rise coming in April 2014, said Putnam.

Although some industry observers may see the liquidity increase as an influx of institutional investors to increase their emerging-market exposure, Saxo Banks spokesperson takes a contrary view.

Overall, the real-money sector, a key participant and driver of emerging market FX liquidity, was hurt in emerging-market bonds extensively through the middle of last year, he said. So a lot of the exodus and real emerging-market FX depreciation versus a basket of euro and U.S. dollar is being attributed to this real-asset liquidation.