(Bloomberg) -- Recent bouts of currency volatility in the developing world have prompted Pacific Investment Management Co., one of the largest emerging-market investors, to question the efficacy of a floating exchange rate regime.
Pramol Dhawan, head of the EM team at the $2 trillion asset manager, said swings in currencies like the Mexican peso and Brazilian real have gotten so high that it’s become a hurdle to investing. On the other hand, countries like Egypt, Nigeria and Dominican Republic, where authorities keep a controlled FX policy, have become more interesting, he said.
“It’s not necessarily obvious to me that fully free-floating exchange rate regimes have been that positive,” Dhawan said in an interview at Pimco’s New York offices. “As a foreign investor, I’m taking on all of that risk myself. I’m wearing all of that FX volatility.”
The unwinding of yen-funded carry trades, choppy domestic politics, geopolitical conflicts and the threat of protectionist policies under a second Donald Trump administration in the US have boosted swings in the currency markets in the past few months. Implied volatility in developing-nation currencies jumped to the highest since 2022 earlier this month, and is now hovering around the highest in more than a year.
Mexican peso’s three-month implied volatility has jumped over 300 basis points this year to 15%, the highest since early 2021. A similar gauge for the Brazilian real climbed 170 basis points to early 2023 levels. Meantime, implied volatility for the Turkish lira has remained relatively stable this year and the measure for Indian rupee is even hitting record lows.
“You can lever the Indian rupee 10 times and get a much better return on investment than you can with Mexican peso,” Dhawan said.
Glimpse of History
Economists and policymakers have long debated what’s the best exchange rate policy for developing nations, one that allows them to weather external shocks and attract foreign investment while also abiding by free-market principles.
For decades, under the International Monetary Fund’s recommendation and after harsh lessons from a series of financial crises in the 1980s and 1990s, emerging-market governments shifted to more flexible exchange rate regimes, according to Ethan Ilzetzki, professor at the London School of Economics. But many shied from letting it free float entirely: About two-thirds of countries in the world still have pegs or a managed currency, according to the IMF.
Even though many governments still intervene to various degrees in their currencies, a generally more flexible exchange rate has worked well for emerging markets, said Carmen Reinhart, economist and professor at the Harvard Kennedy School.
“A big payoff of exchange rate flexibility has been that they’ve been able to withstand adverse external shocks better than they did in the past,” said Reinhart. The last time the Federal Reserve hiked interest rates aggressively was Paul Volcker’s tightening in 1979 when “most of the emerging markets went into crisis,” she added. “This time they did not.”
High Volatility
But to investors like Dhawan, the swings have become a deterrent. When taking into account how much currency moves play into volatility for the nation’s assets, the math, he said, doesn’t add up.
“Those that opt for full free-floating exchange rate regimes, like Brazil and Mexico, have seen the additional volatility result in investors demanding increased risk premium to own their fixed income assets,” he said.
In contrast, Peru’s currency has gained praises not just from Dhawan but from UBS and Standard Chartered Bank.
While interest-rate cuts could put pressure on the sol, UBS’s Pedro Quintanilla-Dieck believes that the central bank’s FX intervention program and rising metal prices will offset that impact. The sol’s low global liquidity also shields it from bouts of risk aversion, he added.
“That’s the most managed currency that we’re covering and it’s a big outperformer,” said Gordian Kemen, head of emerging markets sovereign strategy at Standard Chartered. “Lower FX volatility has helped.”
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