Rupee, Won, Lira Rally Dies as Inflation Hits Emerging Markets

By Lukanyo Mnyanda and Lester Pimentel

July 21 (Bloomberg) -- The five-year rally in emerging- market currencies is coming to an end as central banks from South Korea to Turkey struggle to contain inflation, say DWS Investments and Morgan Stanley.

The 26 developing-country currencies tracked by Bloomberg returned an average 0.96 percent in the past three months, down from 1.63 percent in the first quarter, 8.2 percent for all of 2007, and 30 percent annually since 2003. For the first time in seven years, investors are less bullish on emerging-market stocks than on U.S. equities, a Merrill Lynch & Co. survey showed last week.

Confidence in the Indian rupee is weakening after inflation accelerated at the fastest pace in 13 years, stoked by soaring food and energy prices. South Korea's won will drop this year by the most since 2000, while Turkey's lira will reverse its biggest gain since at least 1972, the median estimates of strategists surveyed by Bloomberg show.

``There are some countries that suffer from weak institutions, where central banks have not been proactively fighting inflation and sentiment has deteriorated,'' said Nicolas Schlotthauer, a fund manager in Frankfurt at DWS Investments, which oversees about $400 billion. Schlotthauer said he expects the Indonesian rupiah and the Philippine and Colombian pesos to underperform emerging-market assets.

Food and energy prices account for more than 40 percent of inflation in India, Thailand and Turkey, compared with about 25 percent in the U.S., according to Morgan Stanley. Inflation exceeds targets in at least 19 emerging economies.

Slovakia to Brazil

The developing-economy currencies tracked by Bloomberg strengthened an average 32 percent in the past five years, led by gains of 94 percent in Slovakia's koruna and 93 percent in Poland's zloty as those nations forged closer ties with the European Union. In Latin America, Brazil's real has surged 80 percent while the Colombian peso has climbed 62 percent since 2002 amid a boom in commodities.

Slovakia will adopt the euro next year, while the zloty will depreciate to 3.33 against the dollar by year-end from 3.22, according the median estimate of strategists surveyed by Bloomberg. In South America, the real will weaken to 1.70 by the start of 2009 from 1.59 and the peso will decline to 1,888 from 1,805, the surveys show.

Emerging-market and high-yield bonds are poised to fall this year for first time since 1999, a Merrill Lynch index shows. Investors prefer U.S. equities over developing economies' stock markets for the first time since 2001, according to Merrill's July survey of money managers who oversee $610 billion. A net 4 percent of investors said they were ``overweight'' emerging markets, down from 25 percent in June.

`More Challenging'

``It's going to be a more challenging environment for emerging markets as you're going to see less portfolio flows,'' said Koon Chow, a Europe, Middle East and Africa foreign-exchange strategist at Barclays Plc in London. ``People are focusing more on the domestic fundamentals like fiscal and monetary policy credibility. In the past, there was less differentiation.''

Fitch Ratings cut the credit outlooks in the past month on South Africa and India, whose currencies gained 74 percent and 18 percent in the five years through 2007. The South African rand slumped 11 percent this year and the rupee 9 percent as investors bet rate increases won't contain inflation and the countries struggled to boost growth and pull millions of people out of poverty.

Shortcomings `Exposed'

The World Bank estimates that about half of India's 1.1 billion population survives on less than $2 a day, while 23 percent of South Africa's workforce is unemployed, the highest rate among the 61 economies monitored by Bloomberg. That limits the ability of their central banks to fight inflation through higher borrowing costs.

India's rupee will weaken 8 percent, its worst year in a decade, while the South African rand will lose 22 percent, its worst performance since 2001, the Bloomberg surveys show.

``The shock of higher food and energy costs has exposed the major shortcomings of emerging economies in controlling inflation,'' said Stephen Jen, chief currency strategist at Morgan Stanley in London and a former Federal Reserve economist. ``I'm not sure emerging markets will respond to inflation shocks.''

Betting against currencies of emerging markets is risky because the oil and food producers among them benefit from higher prices, and those that are able to tackle inflation will attract investment, said Peter Eerdmans, head of emerging-market bonds at Investec Asset Management in London. Crude oil almost doubled in the past year, reaching a record $147.27 a barrel on July 11.

Energy Producers

``The beauty with our universe is that it's so diverse and there are so many stories to play,'' said Eerdmans, whose firm has $60 billion in assets. ``A lot of the bad news has started to come into the price and we see tactical opportunities.''

Eerdmans said Investec has ``long positions'' in the currencies of Nigeria, Malaysia and Russia, which are benefiting from higher oil prices and foreign direct investment, allowing them to fight inflation through currency appreciation. A long position is a bet that an asset will increase in price.

The Malaysian ringgit, which gained 6.11 percent in 2007, is up 0.24 percent this year to 3.2425, and will likely end the year little changed at 3.18, according to a Bloomberg survey of strategists. A separate poll shows the ruble weakening to 23.51 from 23.22.

For Mark Rall, senior fund manager overseeing $900 million in emerging-market debt at Union Bancaire Privee in Zurich, energy exporters including Russia and Brazil are attractive. Countries with growing current-account deficits, such as South Africa and Turkey, should be avoided, he said.

Wider Deficits

The Turkish lira will fall 12 percent, reversing a 17 percent advance during 2007, according to analysts' forecasts compiled by Bloomberg. Korea's won is likely to fall 0.6 percent.

Turkey's current-account deficit may swell to a ``worrying'' $50 billion by year-end, Moody's Investors Service said July 9. South Africa's deficit will probably remain ``large and persistent'' as the country will have to rely on foreign capital to boost investment, Finance Minister Trevor Manuel wrote in the country's Star newspaper July 14. The shortfall reached a 26-year high of 9 percent of gross domestic product in the first quarter.

``You have to analyze policy behavior as those that are doing the right things will do better,'' Rall said.

The reluctance of central banks in emerging markets to raise rates amid faster inflation will also hurt local-currency denominated bonds, said Edwin Gutierrez, who manages $5.5 billion in emerging-market debt in London for Aberdeen Asset Management Plc.

``Inflation is what keeps me up at night,'' said Gutierrez said. ``It's the biggest challenge going forward in emerging markets.''

To contact the reporters on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net; Lester Pimentel in New York at lpimentel1@bloomberg.net