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The Case for Emerging Market Currency Investment

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The Case for Emerging Market Currency Investment

The case for Emerging Market currencies

As emerging market (EM) countries become richer their currencies become stronger and in so doing

their currencies converge with those of developed countries. One of the most compelling arguments

for this is based on the convergence of EM per capita income towards that of industrialised (OECD)

countries. This is probably best explained by the work of the economists Balassa and Samuelson.

According to the Balassa-Samuelson (B-S) effect the real exchange rate (i.e. how many real goods

does a particular currency unit actually buy) is broadly a function of relative productivity growth over

the longer term. Countries that exhibit high productivity growth are likely to have a tendency to see

rising domestic prices and thus an appreciating real exchange rate.

As EMs achieve high productivity growth in their economies the Balassa-Samuelson effect becomes

a powerful driving force for EM currency returns over the long-term. Furthermore, because most EM

economies now have inflation targets (both explicit and implicit) most of this real appreciation will

come via nominal currency appreciation rather than just inflation.

Empirical Evidence

Is there empirical evidence to support this hypothesis by Balassa and Samuelson? Put simply, do

richer countries have higher real exchange rates? The chart below plots per capita income on the

horizontal axis, and the exchange rate relative to PPP1 (vs the US Dollar) on the vertical axis. In the

absence of the Balassa-Samuelson effect, relatively richer countries should not experience stronger

real exchange rates. However, the evidence shows that this is clearly not the case. Indeed the

empirical evidence points to a robust and stable positive relationship between real income per capita

and the real exchange rate. Countries with a higher per capita income level are closer to their PPP


Convergence Path

GDP per capita vs. relative exchange rate








0 10,000 20,000 30,000 40,000 50,000

GDP per capita ($)


1 PPP stands for Purchasing Power Parity which compares the purchasing power of different currencies in their home countries

for a given basket of goods. Using a PPP basis is arguably more useful when comparing differences in living standards on the

whole between nations because PPP takes into account the relative cost of living and the inflation rates of different countries.

If going forward globalisation continues to operate as a powerful driving force, we can expect that the

rising income per capita trend in emerging markets will continue to push their exchange rates toward

PPP levels.

Why currency, not bonds?

While EM fixed income investment achieves probably the most similar risk/return rewards to that of

EM currency investment, there are several reasons why EM currency investment is a better

alternative to EM fixed income. First, our research shows that for equities as well as bonds a

significant part of the return comes from the currency component. This calls for an independent

allocation to currency as a return stream in its own right. Secondly, liquidity in EM currency is superior

to that of bonds: by its very nature each EM bond transaction requires a currency purchase, but the

converse is not true. This means that both in terms of liquidity and transaction costs, EM currency

offers substantial benefits. Thirdly, the EM bond market is heavily skewed to countries with high debt,

so that the bulk of issuance, and thus of EM bond benchmarks, will be relatively 'overweight'

currencies such as South Africa and Turkey, and 'underweight', say, China and Korea. In some

instances, access to domestic bond markets by external investors is impractical, illegal or prohibitively

expensive. Finally, there is credit risk. An EM bond exposure may ultimately entail an element of

undesired and unrewarded credit risk of an entity registered in an EM jurisdiction. EM currency

forward contracts are bilateral contracts between two (typically) developed country based

counterparts, thus mitigating the potential (undesired) credit risk of an EM registered entity.

Why currency, not equities?

In a similar fashion to bonds, a significant part of the return from international, unhedged EM equity

investment has come from the currency component. We estimate this



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