Oil and EM Currencies – What’s Different This Time
Just as in 2008, 2010, and 2011, oil prices have escalated in 2018, reaching 70% on a year-over-year basis by June. This time, however, the drivers are different – as is the impact on emerging markets (EMs). Instead of the appreciation in EM currencies that usually occurs when oil prices rise, this time these currencies depreciated, and local markets are feeling the pain as the dollar strengthens.
Previous increases in the price of oil were driven largely by rising global demand; this time the driver is mainly lower oil supply. Opec production cuts have eroded a worldwide glut over the past 18 months and supply is likely to fall further when new US sanctions take hold against Iran. Therefore, despite Opec’s recent deal to boost supply somewhat again, the net balance should remain tight. In addition, pipeline capacity constraints in the Permian Basin and Eagle Ford Shale area will limit the supply of US shale oil for the next 12 months or so.
The new oil supply/demand equation is affecting the relative value of the dollar, which instead of declining as it did during previous periods of rising oil prices currently is appreciating. (We also saw this dynamic in late 2016 and early 2017, but it was short-lived.) When oil prices increase simultaneously with dollar appreciation, those EM countries that are oil importers start to feel significant pain. According to our calculations, energy comprises 9.4% of the Consumer Price Index (CPI) in EM nations on average, which is not significantly higher than the 8.6% in developed markets. But since food makes up 28.3% of the CPI basket in EM, on average, versus 13.6% in developed markets, any persistent currency weakness is likely to show up as a secondary inflationary risk in the future.
From a technical perspective, oil’s recent upward move has brought it into a likely new range of at least $70 to $80 per barrel (bbl). Given a possible prolonged period of higher oil prices, we evaluated the effects of the rise in oil prices on EM currencies barring those whose pegged or semi-pegged currencies mask the price impact. As one might expect, oil exporters tended to be the winners, while importers were more likely to suffer, although the degree to which exporters won and importers suffered varied considerably.
Measured from 2008 to this year’s first quarter, and using monthly data, winners include the currencies of Russia, Kazakhstan, and Colombia, which rose 4.4%, 4.2%, and 3.1%, respectively, for every 10% jump in the oil price. Although it’s not an oil exporter, Ukraine also tended to perform well during periods of rising oil prices due to its close link to Russia; remittances, mainly from its neighbor to the north, were 6.5% of GDP in 2016, according to the World Bank.
Countries that fared the worst include Belarus, Vietnam, Kenya, the Philippines, and India. Belarus and Vietnam saw currency depreciation of 0.3% and 0.1%, respectively. Kenya and the Philippines fared worse on a relative basis, as their currencies appreciated by 0.5% and 0.6%, respectively, compared with the average 1.8% appreciation posted by the EM universe over this period. Another major oil importer, India, saw its currency strengthen by a below-average 0.9%.
This year EM currencies as a group suffered in the face of rising oil prices, declining about 5.3% from mid-April through the end of May, when oil peaked at just below $80/bbl. But here, too, the effects were wide-ranging among individual countries. For instance, Ukraine, Russia, and Kazakhstan saw their currencies appreciate by 1.3%, 0.5%, and 0.2%, respectively.
At the other side of the spectrum, net oil importing countries with large current account deficits saw their currencies depreciate. Turkey, sporting a wide deficit of an estimated 5.7% this year, saw its currency lose 13.9% over this period, although liquidity concerns also played a role. Pakistan’s crawling currency peg has increased by 9.9% against the dollar since mid-March.
In oil-importing Belarus, by way of contrast, the ruble held up better than usual and appreciated slightly over the same period largely due to the country’s improving external dynamics. Its current account deficit as percentage of GDP improved to 1.7% currently from 14.5% in 2010.
Oil prices touched $72/bbl in mid July, a 9% drop from the peak earlier in the month. The subsequent creep higher toward $75/bbl has reinforced the $70-$80/bbl range.
Against this backdrop, EM currencies have started to recover during the last week of July and posted the strongest weekly performance since February this year. One clue is dollar strength, which has run out of steam. Also, on an annualized basis, oil price gains are starting to soften given the sharp trend higher from mid-June 2017 to end of January 2018, alleviating the threats to inflation and economic growth. The relative impact of oil on various EMs still holds in such a scenario and the “winners” are likely to see their currencies appreciate by more.
Dmitri Savin (above left) is sovereign portfolio manager and Ilke Smit sovereign analyst, emerging markets fixed income at PineBridge Investments