The Volatility of Emerging-Market Currencies — Why Do They Swing So Much

Emerging-market currencies have far higher volatility than developed-market currencies like the U.S. dollar or the euro. There are structural reasons.

First, because the economy and financial market are relatively small, the currency moves greatly even when funds come and go a little.

Second, inflation is often high, putting steady downward pressure on the currency's value.

Third, many are countries with a lot of dollar debt. When the currency weakens the debt to be repaid swells, easily falling into a vicious cycle of selling the currency again.

Fourth, political and institutional uncertainty is high, so investor confidence is easily shaken. When these four overlap, the currency can plunge at any time.

2018 was a harsh year for emerging-market currencies.

The trigger was U.S. rate hikes. As U.S. rates rose, funds that had been chasing high interest returned from emerging markets to the U.S. (capital outflow).

The one hit hardest by that shock was the Argentine peso, which plunged about -37.7% versus the start of 2018. The Turkish lira also recorded the second-largest decline among emerging-market currencies, and the Brazilian real fell about -16.7%.

The common feature was clear. These countries carried a 'risk set of four'—large current account deficits, high inflation, excessive external debt, and political uncertainty. It is exactly the pattern we saw earlier in currency crises.

The most common mistake when investing in emerging-market assets is looking only at the 'local return.'

When a Korean investor invests in emerging-market stocks, the actual profit and loss is the product of two things: the change in the local asset price × the change in that country's exchange rate.

For example, even if the local stock price rises 10%, if that country's currency weakens 30% against the won, in won terms it can actually be a loss. You gained on the asset but lost even more on the exchange rate.

This is the 'double risk' of emerging-market investing. Along with the high growth expectation, you also bear the risk of the currency collapsing. That is why emerging-market assets must always be checked not just for return but for maximum drawdown and the exchange-rate effect. This is why this site shows the exchange-rate effect separately.