On currencies and unhelpful CPI targets


Our 22-year Bruegel-based REER model remains positive on Egypt, Ghana, Tunisia and Kazakhstan, and is now supportive of the rand and Turkish lira too. Separately we find inflation targeting is not protecting currency value in Mexico and SA.

We look at REER values over 22 years and analyse which currencies are most likely to move

By Charles Robertson and Vikram Lopez

MON, JULY 24 2017-We have updated our Bruegel-based REER model that gives us estimates for the fair value of EM, Frontier and African currencies based on the average implied exchange rate since 1995. Amidst the mini-tantrum seen in EM currencies as the markets begin to price in a less loose stance from the ECB, a little more value is emerging. Now seven EM currencies are 3% (Taiwan) to 32% (Colombia) cheaper than fair value, including high yielders such as Egypt and also Turkey and SA. With the start of the new fiscal year, this week we have seen small currency moves weaker in Pakistan (it is at PKR106/$ still the second most expensive EM currency after India) and stronger in Egypt (still the second-cheapest EM currency at EGP17.9/$ after Colombia). Russia remains expensive at RUB60/$ and some distance still from our Russia economist Oleg Kouzmin’s average RUB62/$ 2017 forecast if oil averages $50/bl.

In Frontier, five currencies are now cheap, including Morocco where locals are (in our view) unjustifiably worried about the central bank’s plans to widen the currency’s trading bands. Nigeria’s currency, using the NAFEX rate, is within 2% of fair value. In Africa, our model indicates 10 currencies offering good long-term value, with the best value in Ghana, Tunisia and Egypt.

We also show how often currencies have stayed very strong (more than 20% above fair value) to very cheap (more than 20% below fair value), which shows that while Egypt may be very cheap on this measure, it has been very cheap 24% of the time over the past 22 years. A rapid bounce – back to merely cheap (5-20% below fair value) – is not as likely as it was in SA in 2016.

Taking this into account, real depreciation looks more likely in Ethiopia and the CAR, India and Pakistan, and real appreciation is most likely in Ukraine and Colombia. We can only identify one trigger for a change in Pakistan, which will be the 2018 elections.

Brazil follows Russia’s 4% CPI target, SA may weaken its commitment to low inflation

Meanwhile, it is interesting to see some in the ANC are considering weakening the SARB commitment to lower inflation, while in Brazil, they are attempting to strengthen their commitment by cutting the CPI target from 4.5% to 4.0% by 2020. Russia, for the first time, is among the leaders in achieving this goal. Among these three plus Turkey and Mexico, the IMF expects the least success in achieving low inflation in Turkey and the highest success in Mexico, followed by Russia. SA is in the middle, but at risk of becoming more like Turkey.

Mexico second-worst in maintaining real FX stability, despite success in achieving low inflation

Curiously, though, for investors able to get a local return that equals local inflation (minus US inflation), those owning a local asset rather than dollars have done worst in SA since 2006. The existing SA target is open to criticism. In only three years since 2006 has inflation in SA not been fully offset by currency weakness. The best performance has not come in low-inflation Mexico, but in Brazil. We suspect Brazil’s good performance is due to high real interest rates – which are more likely in the future in Brazil and Russia than Turkey (or perhaps SA). Low inflation does not bring nirvana.

Low inflation helps equity investor returns when it lifts private sector debt ratios

One additional aspect we reiterate is the point about mortgage lending being lifted by low inflation. There has been no big increase in SA private sector debt since 2006, despite it mostly meeting its inflation targets. When Central Europe achieved low inflation, there was a big increase that helped to lift growth and equity returns. We think Russia can echo that.

The Bruegel Group updated its REER model in June 2017, to incorporate inflation figures to April 2017. We have updated our model as a result. The table below shows in the first four columns, the spot rate at 5pm London time on 6 July 2017, the average exchange rate in today’s money since 1995 (oil over this period averaged a little above $60), as well as the level and the date of the lowest REER rate recorded since 1995.

South Asia is expensive, but while India’s current account deficit is this small, and there are high foreign portfolio flows to fast-growing India, we see no obvious trigger for depreciation. Risks are higher in Pakistan, especially as only 3% of the time has the Pakistan rupee been this expensive. We see an obvious trigger for devaluation being the 2018 election. Until then, we believe the government will be reluctant to endorse depreciation, as we saw in the 5/6 July clashes between the finance minister and central bank.

Russia has depreciated in 2Q17, as Oleg Kouzmin and a number of Russian officials were suggesting, but it remains expensive. With a YtD average at RUB58/$, the rouble needs to depreciate further to meet Oleg’s target of RUB62/$ premised on a $50/bl oil price.

The ZAR13.5/$ level is cheap and around the end-year levels Bloomberg consensus has expected. Given still supportive merchandise goods trade data, there is short-term appreciation potential to the ZAR12-13/$ range if global markets become supportive again. We think the same scenario would let the Turkish lira appreciate to fair value.

Egypt remains attractive to us on the currency side, and this week saw the first move stronger in months. This coincided with the beginning of a new fiscal year. We can envisage 10% appreciation from here, but we are more confident in saying we see no depreciation risk (without political unrest). Egypt’s currency has been more than 20% below fair value, in 24% of the months since 1995.

In Frontier markets, we have made a rough estimate for the Argentine peso, which now shows it looking expensive. We caution against using this model as a reliable guide on Argentina, given the lack of reliable inflation data from 2007-2015.

We also do not agree with our 22-year model when it comes to Kenya owing to a change in inflation methodology in 2009. We think our SSA economist Yvonne Mhango’s model, implying fair value at KES124/$, is more realistic. Note the Kenyan shilling has been more than 20% above our 22-year model’s estimate of fair value for 32% of the time since 1995.

We see Vietnam as another China, which has moved up the value-added curve and can therefore sustain a strong currency. Both China and Vietnam have very different economies now than they had in the 1990s. They have, in our view, changed more than Nigeria or Kuwait, for example. Current account surpluses in China and Vietnam support our view that these currencies are not at obvious risk of depreciation.

Kazakhstan and Tunisia still have the most undervalued Frontier currencies, according to our model.

Nigeria’s currency

At the NAFEX rate, it is similar to Algeria or Chad, and just marginally above fair value. Nigeria though has a better current account than either. If inflation is 10-15% over the next 12 months, then fair value should move from NGN371/$ to probably NGN410-425/$ in a year’s time. Investors may find the 20% local yields more than compensate for that loss.

Ghana also looks interesting based on these charts – especially given the dramatic improvement from a trade deficit to a trade surplus this year (which is clearly not what the IMF was forecasting).

There is an important discrepancy in the 22-year REER model and Yvonne’s model for Zambia. We think this is due to copper prices, which today are closer to the average price over 22-years than the average price since 2004 in Yvonne’s model. For more on Zambia, see our other research reports published in 2017.

What is striking about African currencies today is that all of them have been at their relative valuation level at least 13% (nearly three years) of the time over the past 22 years. Tunisia is 17% undervalued, and is therefore close to the 20% level, which it has never hit since 1995. We expect to be enthusiastic about the Tunisian dinar if it loses a few more percent. We already believe it offers good value.

Overall EM currencies (ex-China) remain only a little above fair value, so we still value in EM FX at a time when DM bonds and DM equities look expensive.

On inflation targets: Brazil, SA, Turkey, Russia and Mexico

Should you be concerned about those in the ANC trying to weaken the SARB’s inflation mandate?

Will investors benefit from Russia targeting 4% inflation?

Brazil has decided to cut its inflation target from 4.5% to 4.25% in 2019 and to 4% in 2020. Having had this 4.5% target for years, we wonder if Russia’s new-found success in getting inflation to its target of 4% has encouraged Brazil’s shift. Russian officials told us at our 21st Annual Russia Investor Conference in June 2017 that they intend to reduce their 4% target in the medium term, perhaps towards Mexico’s target of 3%.

This is a big change. Until now, Mexico (3%), SA (3-6%) and Brazil (4.5%) and Turkey (5%), have targeted and achieved lower inflation than Russia since 2006. The future is now likely to be different. From the highest inflation in the past, Russia should now have the second-lowest inflation in this group over 2017-2022. In the table below, we take IMF forecasts for inflation in these countries, minus their forecast for US inflation, to arrive at the nominal loss each year that may be seen in a currency, which would reflect inflation differentials. We have not assumed that the IMF will change its inflation forecasts for Brazil, but we think a modest downward revision to IMF forecasts is likely.

The outliers in EM are clearly Turkey and now SA. Turkey’s 5% inflation target has never had much credibility and still does not. SA’s target of 3-6% is effectively the same as Brazil’s 4.5% (give or take 1.5 ppts), but there is now a chance of a shift in the SARB mandate, which would make SA look more like Turkey.

Has low inflation actually helped investor returns though? Curiously, the country that did worst for investors since 2006 is SA, followed by Mexico, while Russia and Turkey have cost investors a little.

We calculate this by looking at the inflation rate since 2006, and comparing it to CPI (given this is about CPI targets) minus US inflation, to see whether investors who can get a return to equal inflation have been able to compensate for the losses of being in a local currency or not. Whether investors are in equities, real estate, a time-deposit bank account or a local government bond does not matter to us here. We are simply trying to show whether inflation-targeting has helped protect the value of the local currency.

The main winner was Brazil. We suspect Brazil has done best because it has tended to offer the highest real interest rates. While cumulative inflation (over and above the US) was 55% between 2006 and 2016, the average exchange rate shift was 43%. Thus owning any asset that broadly tracked inflation was a better call than owning dollars. By contrast, Mexico with the lowest cumulative inflation increase of just 24% (over and above the US) still saw a currency shift of 72%. We can debate which years we should be looking at, but we chose 2006-2016 because we have data for 2016, not to prove a point. On a purely annual basis, we found that SA currency losses outweighed inflation in eight years out of the past 11, and six years in Mexico and Turkey, but only five years in Brazil and Russia. Over 11 years therefore, inflation-targeting and low inflation does not appear particularly effective in protecting the value of the local currency.

Therefore, the face-value implication of this is that achieving low inflation is not such a good thing for investors in local currency assets. Markets should not be that bothered by the ANC changing the SARB mandate and weakening its commitment to low inflation. In addition, the face-value implication is that Russia is not going to offer investors a much better dollar return by achieving low inflation, unless Russia provides the positive real interest rate experience of Brazil. At present, it is giving a decent real return, and the Central Bank of Russia (CBR) has stated that it is likely to target real rates (around 2.5-3.0%) that will be above what Turkey often offers.

What is excluded from this analysis is the debt cycle. Despite low inflation, Mexicans over the past decade have not greatly increased their private sector debt. Nor have South Africans – their debt boom ended in 2007 and has never returned. Yet the big advantage of getting inflation down is that you can borrow more debt. Our Head of Eurasia Research, Dan Salter, showed this brilliantly in the following chart.

Over 1998-2008, when central European countries got inflation down, they saw mortgage debt rise. Countries with inflation above about 8% never saw significant mortgage growth – except when those mortgages were in euros and therefore were much cheaper than local currency mortgages (Hungary, Latvia). Although they are not shown in the chart below, neither Mexico nor SA have seen mortgages expand in recent years, and high inflation in Russia and Turkey has made large mortgage growth impossible. That should now change in Russia.


At face value, we think foreign investors should not be particularly concerned about those in the ANC who want to weaken the SARB’s inflation mandate. Nor should investors be that excited by Russia cutting inflation towards Mexico’s levels. Inflation-targeting is trendy, but does not offer nirvana.

Investors should be most pleased that Russia is offering a decent real interest rate, as we think that has been key to good dollar returns in Brazil. But we think there is a benefit to investors from a secondary effect of low inflation; it lifts borrowing capacity. Neither Mexico nor SA have taken advantage of that. In the future we believe Russia might and Turkey won’t. While we are short-term bullish on Turkey, we remain long-term bearish.

Charles Robertson is Global Chief Economist at Renaissance Capital| CRobertson@rencap.com| @RenCapMan| Vikram Lopez-VLopez@rencap.com

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