Volatility in Emerging Markets: Resources on Currency and Capital Flows

Emerging markets are vulnerable to aggressive inflows and outflows of money, and that vulnerability has been on display over the past few weeks — especially in the wake of the capital movements that the Wall Street Journal has described as a stampede of mom-and-pop investors.

The value of India’s rupee has been in an unchecked plummet, losing 15% of its value since March. In Indonesia, the government has vowed to take measures to shore up its finances in response to market uncertainty. Bond yields have risen. Some central banks are intervening. With each new headline, investors scrambling to shield their portfolios from damage exacerbate the difficulties, adding more shocks to markets that are already volatile.

Dealing with large and unexpected shifts in capital — this time, in response to signs that the US Federal Reserve will be tightening the monetary spigot — has been an ongoing challenge for central banks and investors alike. Here are some of the discussions around currency fluctuations and capital flows that have taken place at recent CFA Institute conferences — and that help shed some light on the current environment:

• The Impact of Capital Controls on Cross-Border Fixed-Income Investments: Tina Vandersteel, CFA, discusses the ways that countries set their monetary policies, looking at how monetary policy responses can be used to control unwanted capital inflows and outflows, to help fixed-income investors develop an investment framework that anticipates those responses. Read the text version of her speech in Conference Proceedings Quarterly or watch the presentation below.

• Can Emerging Markets Stabilize Capital Flows? Kristin Forbes explains how separating a country’s foreign and domestic capital flows can provide more in-depth analysis, noting that emerging market economies should focus less on stabilizing volatility in capital flows and spend more effort on strengthening their financial systems to withstand that volatility.

• Investors Should Brace for a Return of Currency Volatility: Avinash Persaud shares his seven rules of foreign exchange, explaining that short-term currency movements are driven less by local economic fundamentals and more by investors’ appetite for risk. Persaud also emphasizes that currencies should be thought of like like bonds, not stocks, whose long-run prices are driven by inflation rates.

• Global Currency Hedging: What Role Should Foreign Currency Play in a Diversified Investment Portfolio? John Y. Campbell explains that an investment in a foreign stock is implicitly an investment in a foreign currency, looking at ways that currency hedging can be used to mitigate those investment risks. Campbell also discusses the effect of currency hedging on Sharpe ratios and how currency investors should view movements in interest differentials. Watch Campbell’s presentation in its entirety below.

• Critical Factors for Evaluating Sovereign Credit: While some central banks have pledged that they would take stabilizing measures in the face of exchange rate volatility, the markets are trying to decide whether they are able (or willing) to live up to that commitment. David Riley, managing director of Fitch Ratings Group, lays out some critical questions that must be answered when assessing sovereign credit ratings.

• Financial History: What are the Lessons for Investment Practitioners? The current crisis has been compared to the Asian financial crisis of 1997, and the conclusions drawn from CFA Institute’s Future of Finance roundtable discussion, held in conjunction with Cass Business School, suggest that those comparisons may be useful. Discussion participants – Russell Napier, Robert Jenkins, Geoffrey Wood, and Saker Nusseibeh – noted that learning from financial history is desirable, but far from easy.

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