Over the last few months the trend in the foreign currency markets has been toward countries with current account surpluses and away from nations with a current account deficit. In fact, Goldman Sachs published a Current Account Currency Index which tracks buying currencies with the six largest surpluses and selling those with deficits. In January this index is up 4%, the most since October. Clearly safety is driving this trade, but what about the future? What about countries with current account surpluses that are expected to turn into deficits as global trade continues to slow?
Four developing countries that have ridden the globalization wave to new highs in current account surpluses are also the same countries that are expected to have deficits in 2009. According to the IMF, Brazil, Mexico, Russia, and Turkey have all seen their current accounts increase with globalization. However, that party is over and these countries may be in need of some Alka-Seltzer.
During the financial panic of late fall 2008, each of these countries faced severe market dislocations. Russia and Brazil experienced equity market declines so severe that the markets needed to be closed to restore order. Turkey and the IMF held talks about an emergency stand by fund and Mexico struggled with a voracious drug war. In October, spreads surged on sovereign credit default swaps for these nations.
As the rash that is the financial crisis spreads, investors will continue to shun emerging market economies that are heavily reliant on exporting to a economically weak world. Capital has already begun to flee these nations. In particular, Russia chose to allow its currency to devalue rather than continue its policy of supporting the rouble. This movie has played out before in each nation and the end result was currency collapse and debt defaults.
Since the beginning of this year, the spreads on sovereign debt CDS have begun to increase. One way to play the spreading contagion theme is to short emerging markets bonds. The iShares JPMorgan Emerging Market Debt ETF (EMB) holds roughly 45% of its assets in bonds of Brazil, Russia, Mexico and Turkey. Furthermore, when CDS spreads ballooned in October this ETF cratered.
Looking at the iShares Emerging Market Debt ETF (EMB) and CDS spreads for Turkey, the inverse relationship is clear. As the selling spreads around the globe, emerging market debt could once again be vulnerable. While the likelihood of defaults may be remote, market participants will surely require higher rates to compensate for increased risk.
Disclosure: I am short EMB.
