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What do the Lao kip, Haitian gourde and Uzbekistani som have in common? According to one theory, at least, they could be among the best performing currencies in the world in the next couple of years.
Conveniently, the Balassa-Samuelson effect, identified independently by both Béla Balassa, a Hungarian economist, and Paul Samuelson, an American peer, in 1964, also fits in neatly with the current craze for anything emerging market-related.
This hypothesis stipulates that average prices should be higher in countries with higher productivity (i.e. higher gross domestic product per head). This is clear in The Economist’s Big Mac Index, where prices for the very same culinary delight range from $1.95 in China to $7.20 in Norway.
As a result, countries with above-average real income growth should have rising price levels, relative to other economies, and strengthening real exchange rates.
Given the state of the world, taking advantage of this effect broadly translates into a policy of going long emerging market currencies and shorting their developed-world counterparts.
Indeed, if the World Bank’s economic growth forecasts for 2011 and 2012 are to be believed, it is time to start loading up on the kip, gourde and som, alongside the Indian rupee and Chinese renminbi.
Following Balassa-Samuelson would have been profitable in recent years. James Wood-Collins, chief executive of Record Currency Management, estimates that, since 1998, currencies have accounted for between a third and a half of the returns UK-based investors have earned from emerging market equities.
“There has been a lot of attention on emerging market asset investing, but what is still less understood by investors is how much of the returns are driven by currency, rather than the underlying assets,” he says.
Adherents of the Balassa-Samuelson hypothesis have little doubt this trend will continue.
“When countries go through big fundamental shifts, from agrarian to developed economies, the equilibrium value [of their currencies] goes up. Productivity gains tend to lead to higher exchange rates. In the developed world currencies tend to move around a fixed value,” says Bilal Hafeez, global head of FX strategy at Deutsche Bank. “As Asia develops we do think that should lead to stronger real exchange rates.”
David Bloom, global head of FX strategy at HSBC, adds: “Everybody is absolutely convinced of it. If emerging markets have higher productivity growth than the developed world they should get wealthier relative to us and their call on world assets should go up relative to us.”
The widely foreseen strengthening of emerging market currencies depends, of course, on the emerging world continuing to close the gap, in terms of output per head, with the developed world.
Attempts have been made to quantify the magnitude of this effect. Kenneth Rogoff, a Harvard academic and former chief economist of the International Monetary Fund, has estimated that a 1 per cent rise in a country’s per capita income relative to that of the US translates into a 0.42 per cent rise in its equivalent relative price level.
However, at any given starting point, most countries will not lie on the Balassa-Samuelson equilibrium line, the “convergence path” that countries should follow if their price level/exchange rate rises with income.
A paper by Jeffrey Frankel, another Harvard economist, estimated that countries close half of this divergence from the B-S line in a decade.
Werner Gey van Pittius, emerging markets currency manager at Investec Asset Management, concurs with this thinking, arguing that currencies can diverge from “fair value” because of asset price bubbles, inflationary monetary policy, central bank intervention and inertia.
“Currencies do not instantaneously adjust. You don’t get big-step appreciation; central banks would restrict it,” he says.
Using the Harvard estimates, and factoring in forecasts of 5 per cent growth in emerging markets, 2 per cent in developed ones and a current 10 per cent undervaluation for emerging market currencies, Mr Gey van Pittius forecasts the spot price of emerging market countries will rise by 1.7 per cent a year in the next 10 years – on top of a yield pick-up, or carry, of 2 percentage points.
“It has definitely got an in-built beta,” he says, in contrast to the currency market in aggregate, which is a zero-sum game (any gains by one currency must be cancelled by losses by another), meaning it has a beta of zero.
Record launched an EM Currency Fund, which holds long positions in 13 emerging currencies and shorts in four developed world ones, in December to benefit from this trend.
Mr Wood-Collins at Record argues there are advantages in investing in a pure currency fund, namely greater liquidity, immunity from capital controls or confiscation risk (if positions are held via forward contracts) and greater ease in constructing equal-weighted portfolios.
Mr Bloom at HSBC concurs: “In FX you look in relative terms, whereas for equities and bonds it’s absolute terms, and the relative argument [in favour of EM] is powerful.”
But, of course, a strategy of going long emerging market currencies and short developed world ones is far from guaranteed to produce positive returns.
Humans have a bewildering tendency to extrapolate past trends into the future. Just because emerging markets have demonstrated stronger productivity gains and economic growth than richer countries in recent years does not mean that trend has to continue unchecked.
The example of Argentina, which began the 20th century as perhaps the pre-eminent emerging country, only to spend much of the subsequent 100 years going backwards, in relative terms at least, is a sobering one.
Mr Bloom accepts this, but argues that the case of Argentina “makes the case for buying emerging markets in aggregate, not trying to be too cute. The long term emerging market story is fabulous,” he adds for good measure. “I don’t think anyone would not be in emerging markets for the long term.”
Further, the governments and central banks of many emerging nations have shown themselves to be more than willing to clamp down on any unwanted currency appreciation through sometimes massive intervention.
Currencies such as the Brazilian real and Indonesian rupiah have appreciated markedly against the US dollar in the past decade. However, official intervention means the Chinese renminbi and Indian rupee have risen far less , despite being backed by red-hot economic growth.
Mr Hafeez at Deutsche Bank warns “people are a bit too simplistic in just buying emerging markets”. He argues investors needs to keeps their wits about them and be aware of other factors that can influence the FX market, such as the terms of trade – rising oil prices, for example, will tend to be supportive of the currencies of oil exporters but harm those of major importers.
“There is no free lunch,” he adds. “The empirical evidence is mixed. We wouldn’t rely on Balassa-Samuelson alone to steer a currency view.”