Swinging Real, Won Point to More Pain as Economies Recouple

By Liz Capo McCormick

Sept. 15 (Bloomberg) -- Swings in emerging-market currencies may foreshadow further losses for traders already suffering from the broadest declines this decade.

Volatility in options covering currencies from the Brazilian real to the South Korean won is rising at a faster rate than those for the euro and pound, according JPMorgan Chase & Co. indexes. Rising volatility was an element of past financial market upheavals, including the global slump in stock markets from 2000 through 2002 after the technology bubble burst.

The trigger this time is speculation that developing nations can no longer withstand a simultaneous slowdown in the economies of the U.S., Europe and Japan and the resulting lower appetite for high-risk assets. The 26 emerging-market currencies tracked by Bloomberg are down an average 5.5 percent since June, compared with an increase of 2.2 percent in the first half of 2008.

``Anyone who still believes strongly in the decoupling theory on an economics basis has to throw that book out the window now,'' Mike Moran, senior currency strategist at Standard Chartered Bank in New York, said. ``This has been a second awakening for the currency markets, with the first being that the secular dollar weakness the past couple years has clearly come to an end.''

Morgan Stanley, the second-biggest U.S. securities firm, is advising clients to sell emerging currencies in Asia, Latin America, Eastern Europe and the Middle East, and buy the dollar. Stock valuations suggest that earnings in emerging markets will drop as much as in 2001-2002, when profits fell 18 percent from their peak, New York-based Morgan Stanley estimated.

`Getting Worse'

``Any of these emerging currencies could move down another 5 percent to 10 percent,'' said Stephen Jen, the global head of currency research at Morgan Stanley in London. ``This is a three-month story already, and it's getting worse and worse. What we are dealing with is the aftermath of an energy shock and a credit crunch that is hitting every single economy.''

The global economy will expand 2.8 percent in 2009, just 0.3 percentage point above the pace deemed a worldwide recession and last witnessed in 2001, according to a report released by Zurich-based UBS AG on Sept. 11. Back then, emerging-market currencies fell an average of 6.8 percent.

The biggest losers since June in emerging markets have been the Iceland krona, Czech koruna and Bulgarian lev. Each has fallen more than 10 percent. Only China's yuan has appreciated, gaining 0.15 percent.

Sell Rupee, Won

India's rupee and South Korea's won may decline the most because the ability to buy and sell financial assets such as stocks is easier for foreign investors in those countries than in most other developing nations, Jen said.

The rupee slid last week to 45.715 per dollar, the weakest since October 2006, and has weakened 5.85 percent since mid- year. The won, down 5.66 percent to 1108.85 per dollar since July, is trading near its lowest level since October 2004.

Now, rising volatility may extend declines in emerging- market currencies. Traders use implied volatility to gauge expectations for currency swings and in setting options prices.

Volatility was an element of past upheavals, including the global slump in stock markets from 2000 through 2002 after the technology bubble burst. Swings in developing-nation exchange- rates then outpaced those of the major economies by almost 6 percentage points, according to New York-based JPMorgan indexes.

`Driving Factor'

``Movements in implied volatility are better than any backward looking indicator,'' said Gordian Kemen, a fixed-income strategist at Lehman Brothers Inc. in New York. ``It's very forward looking. When volatility goes up it many times becomes a driving factor on its own.''

Options indicate traders expect the currencies to fluctuate at an annualized rate of 11.9 percent, compared with 8.71 percent on July 25. That's just below the peak of 12.5 percent going back through 2000, when JPMorgan began tracking the data.

What's more, volatility implied from emerging-market options surpassed that of major currencies this month for the first time since June.

JPMorgan's implied volatility index for emerging economies three-month options, stands at 11.9 percent; while its index for developed nations is 11.6 percent. That's a switch from the past year, when volatility in developed nations averaged 1 percentage point more than emerging markets as investors bet a rise in commodity prices produced in places like Brazil, India and Russia would allow their economies to weather a U.S.-led slowdown.

Reserves Bolstered

One-month implied volatility on options for the won has more than doubled to almost 23 percent, the highest since 1999, from 10 percent in July. Implied volatility on the rupee has more than tripled to about 13 percent from 4 percent in February.

The rise in commodities prices has bolstered the reserves of many emerging markets, meaning they may fare better now than in prior bouts of economic weakness, according to Alex Patelis, head of international economics for Merrill Lynch & Co.

``Yes, it's not pleasant, but it's not as bad as it used to be,'' Patelis said in a Bloomberg Radio interview. ``The reason is the shock is emanating from the United States this time around, rather than from emerging markets themselves.''

Foreign-exchange reserves in Brazil have risen 27 percent over the past year, compared with the 43 percent in Russia, 36 percent in China and 25 percent in India, according to data compiled by Bloomberg.

Snap-Back

The potential for a snap-back in stock markets may limit any declines in exchange rates.

Declines in oil, nickel and wheat from records have pushed the MSCI Emerging Market Index down by more than a third since October, leaving the index 25 percent below its 200-day moving average. Over the past two decades, the difference grew this wide only in the aftermath of Sept. 11, the $40 billion Russian default and Mexico's currency devaluation in 1994. Each time, the index rallied 20 percent or more in the next three months.

While the International Monetary Fund expects growth in emerging markets may slow to 6.7 percent next year from 6.9 percent in 2008, that's better than advanced economies, which are likely to decelerate to 1.4 percent from 1.7 percent.

And though volatility is rising, some strategists still anticipate gains in emerging markets. The rupee is forecast to rebound to 43.53 per dollar, while the won will trade at 1109 per dollar by year-end, according to estimates of at least 24 contributors surveyed by Bloomberg.

Brazilian Real

Working against emerging-market currencies is an easing of inflation pressures as commodities including gold and oil decline, meaning central banks have scope to leave interest rates unchanged, or even cut them, said Standard Chartered's Moran.

Brazil's real fell to the lowest level since February on Sept. 11, weakening to 1.8374 per dollar, after central bankers split on whether to raise borrowing costs further. The currency is little changed versus the dollar since December, after almost doubling in the previous five years.

``Emerging market volatility is playing catch-up,'' said Naomi Fink, a Tokyo-based strategist at Bank of Tokyo-Mitsubishi UFJ Ltd. ``There is going to be a further re-pricing of risk that will affect emerging markets. Credit was plentiful in the emerging market countries too.''

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net