"Emerging market currencies - how to benefit from rising food inflation"

Until recently, EM countries have tried to limit the upside potential for their currencies via intervention. Some un-sterilized intervention has fuelled asset price inflation in the domestic economies. A few EM countries have also been cutting rates to help keep their currencies in line, thus fuelling the economic expansion. Many of the items they produce are priced in dollars and this has eased the burden of economic forecasting. But things have changed.

These policies can work well if the economy of the currency they are aligned to is moving in the same direction. The subprime problem has changed all that. Slower US economic growth has prompted the Fed rate cut. To add to the evidence of asset price inflation there is a new threat - food inflation. Following US monetary policy is no longer possible. EM economies are on a different economic trajectory to the US and it makes less sense than in the past to be enslaved by US monetary policy. The EM world has had to live with high energy prices for some time now but higher food prices are a more significant factor. (See table showing food weights within CPI figures). For example food prices make up around 42% of the CPI in Indonesia and only around 10% in the UK.

High commodity prices tend to build EM country reserves and are therefore seen as a good thing. High food prices are more socially unacceptable. They tend to lead to social unrest or even worse, higher wage demands. As a result the authorities are more likely to react to these pressures than they have with asset price and energy price inflation.

With EM economic growth strong and inflationary pressures rising following a US policy change, lowering interest rates is not the right response. Simply raising rates may not be the right response either as the mandate of an EM central bank is different from the G7. They are not all fully independent and most are influenced by political desire to keep growth strong and reluctance to allow their currencies to appreciate.

So what can they do?

Some of these will be good for the long term health of investments in the country, but some will not. For the time being, with EM economic growth strong, many can withstand the negative effects of these actions.

The following table attempts to categorise the countries according to their responses so far.

Currencies that are allowed to appreciate and have tightening monetary policies will do well until such a time that it impacts the domestic economy. They are likely to respond positively to heightened expectations that rates will rise and through reduced intervention from Central Banks. Those that rely on price controls are likely to struggle. Some are at an advanced stage of inflation fighting (South Africa) and are more vulnerable to the negative economic effects. Others such as Brazil and Indonesia are only just starting. Singapore actually uses the value of the exchange rate compared to a basket to manage the inflation problem. Domestic growth is being supported by large FDI (foreign direct investment) driven by construction of two large resorts and property purchases. Resilient portfolio flows have also helped to stoke the domestic economy and inflation is on the rise. The authorities will mange the currency higher to contain the economy and wage rises.

The situation in the Gulf is the most difficult to determine. For the past 20 years they have had their currencies pegged to the dollar. With their major export markets (and a large part of their imports) priced in dollars this has made perfect sense. However as they gradually diversify their economies away from a US dollar base, they have to consider moving away from the US$ peg. This is especially true since their economies are a lot less correlated with the US economy. If the US can slow-down and the rest of the world doesn't, then demand for what they produce will remain high. Meanwhile inflation in Saudi Arabia has reached a 10-year high. So far the Gulf States (excluding Kuwait) have resisted the chance to let their currencies go and have partially followed the US rate cut. This situation can't last and over time the authorities may have to let their currencies go. So if you buy their currencies now you get a higher yielding dollar with a large amount of reserves behind it, and perhaps the potential forcurrency appreciation.

The hard currency debt of EM countries with high levels of reserves remains an attractive place to invest. Increasingly there are also opportunities to invest in the local currency markets and benefit from currency appreciation.

FOR PROFESSIONAL INVESTORS ONLY