Emerging market currencies (EM currencies) represent the currencies of developing economies that are not yet fully developed but are progressing towards industrialisation and increased global economic influence. These currencies typically exhibit unique characteristics that distinguish them from those of major economies, and their behavior can be influenced by a variety of factors, including economic growth, geopolitical events, and commodity prices. Understanding how emerging market currencies behave is essential for forex traders, investors, and anyone interested in global financial markets.

Characteristics of Emerging Market Currencies

Emerging market currencies often display certain traits that are shaped by their economies’ developmental stages, their reliance on exports, and the political environments in which they exist.

1. High Volatility

Emerging market currencies are generally more volatile than those of major economies. This volatility arises from several factors:

• Political Instability: Emerging markets often face political uncertainty, corruption, or social unrest, which can lead to rapid currency fluctuations.
• Economic Fluctuations: These economies can experience sharp shifts due to changes in growth rates, inflation, or fiscal policies.
• Capital Flows: As these markets are developing, they are more sensitive to capital inflows and outflows, which can create significant volatility.

2. Dependence on Commodity Exports

Many emerging market countries are major exporters of commodities like oil, metals, and agricultural products. As a result, their currencies are closely tied to global commodity prices.

• Oil Exporters: Countries like Russia, Brazil, and Nigeria are sensitive to oil prices. A rise in oil prices can strengthen their currencies, while a fall can weaken them.
• Other Commodities: Other emerging markets depend on agricultural products, metals, and minerals, meaning their currencies can be impacted by price changes in these goods.

3. Sensitivity to Global Risk Sentiment

Emerging market currencies often behave in line with global risk sentiment. They tend to be more vulnerable during times of economic or financial uncertainty, as investors seek the safety of more stable currencies like the US dollar, euro, or Swiss franc. Conversely, in times of risk-on sentiment (when investors are more willing to take risks), emerging market currencies can strengthen due to higher demand for assets in these economies.

• Risk-Off Sentiment: In uncertain times (e.g., financial crises, geopolitical events), investors may flee to safe-haven currencies, causing emerging market currencies to depreciate.
• Risk-On Sentiment: During periods of economic stability and growth, emerging market currencies tend to appreciate as investors seek higher returns.

4. Interest Rates and Inflation

Interest rates set by central banks in emerging markets can have a strong impact on the value of their currencies. A higher interest rate typically attracts foreign investment, which strengthens the currency. However, inflation is often higher in emerging markets, which can erode the value of their currencies over time if not managed properly.

• Higher Interest Rates: When an emerging market central bank raises interest rates, it can attract capital inflows, leading to currency appreciation.
• Inflation: High inflation can erode the value of a currency by reducing its purchasing power, which often leads to a depreciation in its value.

5. External Debt and Currency Devaluation

Many emerging market countries carry substantial external debt, which is typically denominated in foreign currencies like the US dollar. If a country struggles to meet its debt obligations, its currency can devalue, leading to inflation and instability.

• Debt Crises: A significant risk for emerging market currencies is a debt crisis, where high levels of borrowing lead to fears of default and currency depreciation.
• Currency Pegs: Some emerging market currencies are pegged to major currencies like the US dollar. If the country’s economic fundamentals worsen, maintaining the peg can become difficult, potentially leading to a devaluation.

How Emerging Market Currencies Behave During Different Scenarios

1. During Periods of Economic Growth

Emerging market currencies tend to appreciate when their economies experience robust growth. Higher growth rates attract foreign investment and create demand for the local currency.

• Example: The Indian rupee (INR) and the Turkish lira (TRY) may appreciate during periods of strong growth as investors seek to capitalise on growing markets.

2. During Commodity Price Fluctuations

As mentioned earlier, many emerging market currencies are highly correlated with commodity prices. A rise in oil, gold, or agricultural commodities can strengthen the currency, while a sharp decline in prices can lead to a depreciation.

• Example: The Russian ruble (RUB) tends to rise when oil prices are high, as Russia is a major oil exporter. Conversely, when oil prices drop, the ruble tends to weaken.

3. During Political or Geopolitical Instability

Emerging market currencies are particularly sensitive to political events and instability. Elections, regime changes, and civil unrest can cause sharp fluctuations in these currencies as investors react to perceived risks.

• Example: The Venezuelan bolívar (VES) has experienced extreme depreciation due to ongoing political and economic turmoil in Venezuela. Similarly, the Brazilian real (BRL) can be highly volatile around election times.

4. During Global Economic Uncertainty

Emerging market currencies tend to underperform during global economic uncertainty, as investors flock to safer assets. For instance, during the COVID-19 pandemic, many emerging market currencies depreciated significantly as investors sought the safety of the US dollar and other stable currencies.

• Example: During the global financial crisis of 2008, the South African rand (ZAR) and the Mexican peso (MXN) lost significant value as risk sentiment shifted toward safe-haven assets.

5. During Global Trade Tensions

Emerging market currencies can also be affected by global trade tensions, particularly if the country in question is a major exporter. For example, a trade war between the US and China can lead to depreciation in currencies of emerging economies that rely on exports to these markets.

• Example: During the US-China trade war, the Chinese yuan (CNY) experienced significant depreciation as the Chinese economy was impacted by the tariffs and trade restrictions.

How to Trade Emerging Market Currencies

1. Monitor Commodity Prices

Given the high correlation between commodity prices and emerging market currencies, keeping an eye on global commodity markets is essential for traders. A rise in commodity prices, such as oil or metals, can signal opportunities to buy currencies from commodity-exporting countries.

2. Watch Economic Data

Economic indicators such as GDP growth, inflation, trade balance, and employment data are crucial for forecasting currency movements in emerging markets. Strong economic data from an emerging market economy can lead to currency appreciation, while weak data can have the opposite effect.

3. Stay Updated on Geopolitical Events

Political and geopolitical risks play a significant role in the behavior of emerging market currencies. Stay informed about elections, government policies, and regional conflicts that could impact the currency.

4. Risk Management

Due to the higher volatility of emerging market currencies, traders should use proper risk management techniques, including setting stop-loss orders, using appropriate position sizes, and diversifying their trades to reduce the impact of unexpected price movements.

FAQs

Why are emerging market currencies more volatile?

Emerging market currencies are more volatile due to political instability, economic fluctuations, lower liquidity, and sensitivity to global risk sentiment and commodity prices.

How do commodity prices affect emerging market currencies?

Many emerging market currencies are linked to the value of commodities, especially oil and metals. A rise in commodity prices strengthens the currency, while a decline weakens it.

Are emerging market currencies affected by geopolitical events?

Yes, emerging market currencies are highly sensitive to political instability, trade tensions, and geopolitical risks, which can cause sharp fluctuations in currency value.

What is the role of interest rates in emerging market currencies?

Higher interest rates in emerging markets can attract foreign investment, strengthening the currency. Conversely, lower interest rates can weaken the currency.

How can I trade emerging market currencies effectively?

Focus on monitoring economic data, global commodity prices, and geopolitical events, and use proper risk management strategies due to the higher volatility of emerging market currencies.

Conclusion

Emerging market currencies behave in ways that are influenced by a variety of factors, including economic performance, commodity prices, political stability, and global risk sentiment. Due to their higher volatility, these currencies offer unique trading opportunities but also come with increased risk. By understanding the drivers behind emerging market currencies, traders can make more informed decisions and better manage the associated risks.