Emerging market forex volatility has dominated financial news headlines in the recent past. As the world emerges from a decade of expansionary monetary policy, one can expect a realignment of the risk metrics across the spectrum. What noted investor Benjamin Graham said -- "In the short run, the market is a voting machine, but in the long run it is a weighing machine" -- holds true as one tides over the volatility.
For countries such as India that are looking to create vital infrastructure to further boost economic growth -- and for investors seeking long-dated investments that deliver requisite returns -- such periods of volatility provide an opportunity to learn some critical lessons -- lessons that help implement structural changes that prepare one better for future periods of volatility.
The decade after the Lehman debacle saw expansionary monetary policy, the likes of which is unprecedented in modern economic history. As central banks gradually withdraw liquidity from the financial system and economies such as the US hike interest rates, the emerging markets face significant pressures on their currencies. Besides the macro factors at play, each country -- ranging from the likes of Turkey and Argentina to India -- has its own story that impacts the currency to a large extent.
There is a "macro-impact" on emerging market currencies of rising interest rates in the developed economies. Then there is a "country-specific" impact driven by local dynamics, trade balances and political economy. For India, one major factor is the country's dependence on energy imports. Debates around the taxation structure of energy are appropriate, but the larger structural solution is for India to move towards being less dependent on imports. This move can be through both building on the renewable energy programme and further utilising the oil and gas reserves in India.
To achieve both the objectives above we require innovative policies and consistent policy implementation. Policies such as the Open Acreage Licensing Policy (OALP) that bring flexibility to oil and gas exploration are a step in the right direction. Continually utilising feedback to improve on policy frameworks and their implementation is crucial for India to move towards promoting greater use of alternative energy sources that can be sourced domestically.
Macro-volatility also affects global investors who, in an increasingly globalised investment climate, have significant emerging market exposure. Firstly, as India and the rest of the emerging markets become more significant components of the global economy, investors must allocate an increasing part of their portfolios to the emerging markets across various asset classes.
The Wall Street Journal recently reported how Tennessee's state retirement system is facing increased volatility in its portfolio as emerging markets face a volatile macro-environment. Such volatility is an issue that isn't going away but must be dealt with effectively. Asset managers have increased their emerging market exposure over the years and will continue to do so as economic growth rates remain high in such parts of the world. Macro-volatility will have to be priced in better into the portfolios.
Secondly, asset managers in the developed world need to invest in high-growth economies to achieve their target returns. For example, a recent study by Moody's Investor Service estimated that public pensions in the US are underfunded by $4.4 trillion. In common parlance, this means that the money such pension funds must payout is significantly more than the current value of their assets. This need for higher returns to meet investment targets implies that capital from pension funds must find optimal investment opportunities in high growth rate countries such as India.
The essential component of investing for investors in countries such as India is being able to ride out the short-term volatility and realising the value in their portfolios over the medium- to long-term. Given the linkages in the world economy, to not expect emerging market currencies to be volatile in the face of rising interest rates globally would be a bit naïve. Therefore, the key for investors is to have a long investment horizon and a risk management framework that prices in the volatility.
Periodic market volatility is in the very nature of financial markets. The crucial component is creating structural advantages that equip one better to handle such volatile periods. Both emerging market countries such as India as well as investors keen on emerging market exposure have some essential takeaways from the recent re-pricing of risk.