Many EM currencies have fallen sharply in recent years, including the Turkish Lira, Colombian Peso and Russian Ruble. 

The sharp drop in the Peso reflects another BoP “sudden stop,” which is likely to carry far-reaching consequences for the economy. The IMF forecast of -1.3% growth in 2019 assumes a recovery in H2, but that is now unlikely and a number at or below -2.5% is conceivable. As a counterpart to this, current account adjustment will accelerate, with the Peso now significantly undervalued in our fair value model.

Currency tensions among advanced countries are on the rise, driven by the perception that the US Dollar could be overvalued. We now use our currency valuation framework to examine US Dollar valuation, and look today at the size and composition of the US current account. The US current account deficit is almost entirely (80%) with China. Dollar overvaluation, if it exists, is therefore mostly versus EM Asia.

Since the height of the Lira and Peso sell-off in August 2018, both currencies have weakened sharply in real effective terms. While both have seen their current account deficits narrow sharply, this is mostly due to cyclical weakness and not genuine rebalancing. This is why our FX fair value model signals that both the Lira and Peso are only fair and not undervalued.

We backtest our valuation signals by looking at subsequent REER moves. We find substantial predictive power in Brazil, India and South Africa,which is where our model currently signals material misalignments.

Our EM FX fair value estimates update prompted lots of questions on the inner workings of our model which we lay out in a series of equations and a summary table in this piece.

This Global Macro Views updates our fair value estimates for EM FX, incorporating large exchange rate, current account and activity moves. Argentina’s Peso and the Turkish Lira are only mildly expensive here, while India, Indonesia and South Africa remain overvalued in FX terms. EM Asia continues to be significantly undervalued, including China.

We unveiled our EM FX valuation framework one year ago today, which signaled substantial overvaluations for Argentina and Turkey. Our model says that both currencies have converged to near fair value. But neither is cheap as current account adjustment is mostly cyclical.