Fears of deflation along with a rising risk of competitive devaluation has been behind the emerging market currency rout recently and "this is not necessarily the end of it", says Khoon Goh of ANZ Research.
For instance, in a particularly bad day of trade, the rupee today slumped to 66.5 per US dollar.
But in an interview with Sonia Shenoy and Reema Tendulkar, Goh said traders were unwinding a lot of popular trades that had been in favour of emerging market currencies in the risk-off environment and this could continue to take a toll on currencies.
Below is the transcript of the interview on CNBC-TV18.
Sonia: There is a bloodbath in the currency market as well this morning and since the Chinese government depreciated the yuan on August 11, the rupee has fallen about 3 percent. Do you see more downside in store for some of these emerging market currencies?
A: I am afraid there is going to be further pressure on emerging market currencies. I do not think this is necessarily the end of it. The Chinese depreciation has suddenly sparked concerns about competitive devaluation but the disappointing China Purchasing Managers’ Index (PMI) numbers that came out last week has also ignited the concerns about a China slowdown and the impact that they will have on rest of the region's growth prospects.
I think what we are seeing here is that not only funds pulling out from emerging markets (EM) -- I think we are seeing also quite a lot of unwinding of previous currency bets, which used the euro as a funding currency in order to gain exposure into Asian currencies.
For example, shorting euro-INR was a very popular trade last year or early this year and we are starting to see quite a lot of those getting unwound which is why we have seen euro trading very strongly despite the overall risk off sentiment where Asian currencies continue to come under selling pressure.
Reema: Since the Chinese devaluation the yuan has only fallen close to about 3 percent odd since then it has been stable, the Chinese authorities have said that this is going to be a one-off event? What is worrying the global currencies, do they fear another round of Chinese currency devaluation, do they fear that we eventually heading into a stage where there is going to be currency wars. What is the key problem for the currency market and how much lower do you expect them to head?
A: After the Chinese devalued their currency they continued to intervene in order to keep the renminbi from depreciating pass 6.40 - that's the onshore support rate.
In that sense while the Chinese authorities say they want to make their currency more market determine, it is quite clear that they are not allowing the market to set the rate. If you look at the offshore renminbi which is the CNH - that is trading closer to 6.47 and that is giving a clear indication of where the market thinks that renminbi will hit.
Once the authorities is finally step back from intervention which is what they say they will do eventually then you will see more pressure on the renminbi which is what the market is worried about that this will see further pressure on the rest of the region's currencies and let us not forget as well the yen.
This kind of risk off environment has seen dollar yen fall which is a natural reaction for yen but Bank of Japan will likely not be happy about the reaction that the currency -- they already struggling to try and achieve 2 percent inflation target. So this might increase the chances of the Bank of Japan potentially engaging further easing in order to weaken the yen and if they were to do that that will surely spark another round of devaluations in the region.
Sonia: What is your prognosis of where the rupee could be by the end of the year?
A: We have revised our forecast last week. We have downgraded the rupee in recognition of the Chinese devaluation and despite us still being pretty comfortable about India's overall macro fundamentals and the benefits they will have from lower commodity price, we just cannot help but recognise that the rupee will not be totally immune. So we are looking at 66.8 for dollar INR by the end of this year.
Sonia: Do you want to revise your target once again after looking at what we have seen today?
A: I do not want to be in habit of revising the target every week. The general direction is clear. I think that is a risk that the currency might overshoot just like some of the other regional currencies have. However, at this stage hopefully the market doesn't get too carried away.