Currency Briefing: Heat on CBoT and other emerging markets central banks

The Turkish lira turned north strongly yesterday after the country’s central bank said it would hold an extraordinary policy meeting today to evaluate recent developments and risk and take steps necessary to uphold its primary mandate of achieving and maintain price stability.

The announcement has been widely interpreted as an indication that the Central Bank of Turkey will raise interest rates aggressively.
In recent days, the lira has endured its sharpest intra-month decline in more than five years as investors abandon the currency on broad concerns over emerging markets and specific concerns of political risk in Turkey.

EM countries yesterday faced renewed pressure to hike interest rates as Brazil warned that others would need to follow its lead in tightening monetary policy. Alexandre Tombini, Brazil’s central bank governor, said the “vacuum cleaner” of rising interest rates in the developed world would suck money out of emerging markets and force other central banks to tighten policy to beat inflation.

Tombini’s pronouncement was doubtless prompted by last week’s abrupt devaluation of the Argentine peso, which provided a sharp reminder of the vulnerabilities faced by some countries as central banks in the developed world tighten monetary policy, ending the recent period of ‘superabundant global liquidity’, a state of affairs which according to some researchers has been unnerving big investors.

Tombini also expressed the more positive view that the normalization of world interest rates was ultimately a good thing for emerging markets because it reflected economic recovery taking hold in the developed world.
Mexico also saw the prospect of higher US rates “as fundamentally good news as it means the US economy is doing better”, according to Mexico’s finance minister, Luis Videgaray Caso.

Tightening of monetary policy in the developed world has nevertheless caused substantial market turmoil and a currency risk that is now “firmly part of the equation”, according to Alan Ruskin, a strategist at Deutsche Bank. In the measured words of Mexico’s Videgaray, the market volatility observed last week has created “issues” for some emerging markets, with investors “expecting corrections”.

For example Brazil has responded to higher inflation by raising interest rates by 325 bps since last April to 10.5 percent. The Brazilian central bank also used $360 billion of its foreign reserves to smooth exchange rate volatility and to dampen inflation running at almost six percent, versus a 4.5 percent target.
Argentina has reportedly spent $135 million in defending its sliding currency.
The exchange rate of international currencies is of course not the responsibility of the US Federal Reserve and if it acts this week as expected, which is to trim a further $10 billion from its bond-buying programme, emerging markets are likely to encounter further currency upheavals unless the FOMC also sends a clear message that it sees such turmoil in EMs and asset markets as risks for the US recovery.
Other emerging markets which could be forced to tighten monetary policy include India, Indonesia and South Africa. All will have to respond to the new “risk on the horizon” as Christine Lagarde, the managing director of the IMF, has called the US Fed’s tapering process.