The surprise announcement that China would allow the renimbi to depreciate by 4.4%, thrust currencies into the spotlight. The term ‘currency war’ is back since it was popularized in 2010 by Brazil’s former finance minister Guido Mantega. Now, the competitive devaluations are spreading across the MENASEA region raising the question of whether the depreciation can have a net benefit economically. That’s the subject of our featured article. Our other article asks whether the natural experiment of a currency depreciation in Kazakhstan can tell us anything about liquidity in Malaysia’s sukuk market.
Currency depreciation—an Emerging Market Achilles heel or an opportunity for growth?
As parts of the global economy continues to face macro-economic pressure, the use of monetary policy is helping to keep many countries from slipping into deflation. Since the beginning of 2015, more than 20 central banks around the world have responded to slowing growth in China and Europe by loosening their monetary policies, cutting benchmark interest rates. These efforts have been led by the European Central Bank (ECB) and the Bank of Japan (BOJ).
While these central banks are loosening rates, the US Federal Reserve is preparing for its first rate hike in nearly a decade which amplifies the effect loosening policy in emerging markets, Europe and Japan has through the exchange rate. Devaluation makes exports comparatively cheaper while raising the cost of imports. The ‘race to the bottom’ occurs when countries compete to achieve a relatively low exchange rate for their own currency.
The rise in the US dollar since the beginning of 2014 has been broad-based, and moved against most emerging market (and many developed market) currencies. Looking from the flip-side from an emerging market perspective, the competitive devaluations often get criticized as being part of a “currency war” but in many respects this is a misnomer. As country’s currency falls, so does the price of their exports, theoretically leading to an increase in economic growth and employment.
Devaluing currencies historically has helped in deflationary times by boosting exports and benefiting domestic producers relative to imports. In order to benefit from the effect of devaluation, it is imperative that the banking system be prepared to manage any defaults on foreign currency-denominated loans. This problem—the so-called ‘original sin’—was a defining part of the 1997/98 Asian currency crisis but the prudential framework is much better prepared to manage the effects of a currency depreciation.
Last week’s drop in the value of the renminbi makes Chinese exports more competitive. Following the renminbi’s depreciation, many other Central Asian and Southeast Asian emerging market economies’ currencies have been under severe pressure to devalue in response. One of the most impacted has been the Malaysian Ringgit, which slid to a 17-year low last week while foreign-exchange reserves fell below the $100 billion mark for the first time since 2010. The Indonesian Rupiah has also been hit hard too; the Ringgit and Rupiah are at their lowest levels against the dollar since the Asian financial crisis.
The Thai Baht, also a casualty in the Asian crises of the 90s, now sits at a six-year low against the greenback. The Singapore dollar is at a 5-year low and is likely to stay under pressure as closer ties develop with China. On an individual country basis, the devaluations might appear as an Achilles heel for growth but, if it is not accompanies by an economic crisis, that the benefit of stimulating exports for EM markets as a whole (particularly with thriving economies like the US), may well be a positive-sum game. For oil exporters, the future is hazy. Oil importers (most of whom have oil as their largest import) may benefit on net as the oil price drop can offset the increase in import costs caused by their currency devaluation.
Kazakhstan sukuk not hit by devaluation
Malaysia’s efforts in developing its Islamic capital markets have focused on developing Malaysia as a center for “strengthening the international interlinkages in the global Islamic financial system” as it was described by Bank Negara Malaysia Governor Dr. Zeti Akhtar Aziz in August 2008. One of the keys she mentioned elsewhere in the same speech was that to internationalize sukuk offered through Malaysia’s capital markets, it was important “to enable non-resident corporations to raise ringgit […] in addition to having the flexibility to swap domestic currency funding into other currencies”.
At a time when both Prime Minister Najib Razak and Governor Zeti are forced to reassure investors that there will be no currency peg, a bigger question is whether the internationalization has been a success. According to the Zawya Islamic Sukuk Monitor, non-Malaysian issuers have issued RM13.4 billion ($3.3 billion at today’s exchange rate) worth of MYR-denominated sukuk. However, all of that was issued prior to the ‘taper tantrum’ in May 2013 suggesting the primary markets are highly reliant on a stable Ringgit (to lower the cost for issuers to swap into hard currencies).
One of the sukuk issued in 2012 before the Ringgit volatility spiked was the Kazakhstan Development Bank. It was swapped to USD in order to match the assets on the bank’s balance sheet which are primarily denominated in USD. Kazakhstan-government related debt has been quite volatile in international markets but the Kazakhstan sukuk has not been volatile. Comparing the spreads (over comparable maturity US Treasuries) of the Kazakhstan Development Bank with the spreads from a USD issuance by KazMunaiGaz (also government owned and with a similar maturity date), the difference is notable.
Despite both representing the underlying creditworthiness of the Kazakh government to repay USD loans (the sukuk was a commodity murabaha transaction)), the spread on the sukuk has remained within a narrow band around 185 bps while KazMunaiGas, another government-owned company saw its spreads for similar maturity bonds rise from around the same level to reach a peak of over 600 bps in March 2015 before falling back to 367 bps on August 19 (Kazakhstan Development Bank sukuk carried a spread of 196 bps the same day). The following day, Kazakhstan allowed the Tenge to float, prompting a huge devaluation which saw the bond spreads rise to 417 bps (+50 bps) while the spreads on the sukuk rose to just 205 bps (+9 bps).
The implication of this natural experiment with spreads rising in late-2014 and early 2015 and beginning to rise yet again following the currency depreciation is that in a liquid market it should attract arbitrage-seeking investors. A few factors may be standing in the way in this case. First, Shariah sensitive investors in the sukuk are not able to either short bonds or effect the same economic return through buying Kazakhstan’s sovereign CDS (on the anticipation of rising yields). Second, non-Malaysian Shariah sensitive investors may not be able to sell the sukuk (because it is a murabaha) at less than par and thus not be able to liquidate their holdings which limits the already low volume that might otherwise be available for trading.
The sukuk offering’s small RM240 million ($58 million) size plays a role in limiting liquidity compared to the $540 million bond from KazMunaiGas. But the limited secondary market (caused by familiar issues of sukuk supply and demand dynamics and Shariah issues for a commodity murabaha issue) may play a further role. One of the advantages Malaysia possesses in developing its Islamic capital market in a way that internationalizes it is that the MYR secondary markets are among the most liquid in the world. However, recent experience with the Kazakhstan’s sukuk and a price distortion between its different bond and sukuk offerings suggests that even a liquid sukuk market remains highly illiquid.