Emerging market local currency debt - a look at Poland

Emerging market local currencydenominated debt is a relatively large and liquid asset class that represents some of the most creditworthy emerging market sovereigns. The asset class offers two distinct sources of return (currency and local bond yields) as well as providing the potential to generate equity-like returns without taking on direct equity risk.

We expect the sizeable economic growth differentials between emerging market countries and the developed world to continue serving as a magnet for capital flows into emerging markets. These capital inflows should augment appreciation pressures on many emerging market currencies, especially in the context of a global economic recovery.

In the following discussion, we examine the interaction between the US dollar and emerging market currencies and look at the prospects for the Polish zloty.

The greenback ache

Emerging market currencies tend to do well when the US dollar weakens against major currencies. The dollar weakness helps directly because the local currencydenominated emerging market debt indices have an exposure to central European countries whose currencies, such as the Polish zloty, trade primarily against the euro. In other words, if the zloty exchange rate remains unchanged against the euro, and if the euro strengthens, then the zloty will usually strengthen against the US dollar. In addition, there is the indirect effect of dollar weakness on other currencies that trade primarily against the dollar such as the Brazilian real and the Malaysian ringgit. For example, while the Brazilian real trades mainly against the US dollar, its economy is much more diversified in terms of its export destinations, with Europe comparable to the US in value.

When the US dollar weakens against the euro, it allows the Brazilian real to strengthen incrementally against the dollar without sacrificing its competitiveness in trade-weighted terms. The corollary of this is that a rebounding dollar can hurt emerging market currencies and the extent of that damage depends on the conditions under which the rebound occurs. When the dollar strengthened against the euro, following the collapse of Lehman Brothers, it reflected the fact that US malaise had spread to Europe and as a result, would lead onto a global recession.

Polish affair with interest rates

Although better than its regional peers, Poland’s economic data continue to point to relatively weak activity, suggesting that interest rates will remain on hold for the foreseeable future. Despite a slower rate of decline in industrial output, the year-on-year contraction is not expected to turn positive until 2010. Sales remain weak, constrained by sluggish consumer spending, while industrial production growth is negative. The high unemployment rate of 11% is not expected to peak before next year. Consequently, the central bank revised its growth projections, with real GDP expected to grow between 1.1% and 1.5% in 2009 and between 0.8% and 2.8% in 2010.

As a result, the policy rate should stay at 3.5% through the second quarter of next year. However, there is a small probability that the central bank could consider yet another interest rate cut over the next two months due to the moderate growth projections for next year and the downside risk to inflation. Accordingly, inflation is likely to remain within the +/- 2.5% inflation target this year and in 2010, although the central bank expects inflation to be even lower in 2010 (between 0.8% and 2.2%) than in 2009 (between 3.3-3.5%). The absence of excise and administered price increases partially explain the lower inflation and increase the chances of downwards inflation surprises in 2010. Economic sluggishness and low inflation are preventing any adverse impact on local interest rates.

Rosy outlook for the zloty

The reversal of risk appetite and concerns about Eastern Europe in general led to a rapid weakening of the zloty, which required significant defensive moves by the central bank, bringing foreign exchange reserves down to US$56 billion in January of this year. Replenishment of foreign exchange reserves has been taking place this year, but these remain about US$10 billion below their peak seen in July last year.

The zloty has since recovered and traded within a narrow range of around 4.2 zlotys/euro over the last four months. Despite recent weakening to around 4.3, the recovery in exports, its fundamental strength compared to Eastern European peers and a resumption of capital flows suggest that the zloty could appreciate towards 4 zlotys/euro by the end of the year and reach 3.8 zlotys/euro within a year from now. The government’s incentive to meet constitutional limits on external debt ratios also argues for a stronger currency in the longer run.