Emerging Markets at Risk From Carry Trade Unwinding, BofA Says

Emerging-market assets are at risk as the tapering of the Federal Reserve’s stimulus program will probably trigger a reversal of $2 trillion in carry trades, according to strategists at Bank of America Merrill Lynch.

Carry trades, where investors borrow in a country with low interest rates to fund purchases of higher-yielding assets elsewhere, helped developing nations raise foreign-exchange reserves by $2.7 trillion since the end of the third quarter of 2008, Hong Kong-based Ajay Singh Kapur and Ritesh Samadhiya at BofA wrote in a research report today. The capital inflows spurred economic growth and inflated prices, particularly those of bonds and property, they said.

The Fed trimmed its monthly debt buying this year by a total of $20 billion to $65 billion and has pledged to gradually reduce the purchases as the job market improves. The U.S. central bank has kept its benchmark interest rate in a range of near zero to 0.25 percent since 2008 and boosted the supply of dollars via its stimulus policy. That compares with borrowing costs of more than 13 percent in Argentina, 7.5 percent in Indonesia and 2.5 percent in Poland.

“As the Fed continues to taper its heterodox policy, we believe these large carry trades are likely to diminish, or be unwound,” the analysts wrote. “We believe carry-trade driven emerging-market asset prices remain at risk, are a global deflationary threat, could drive defensive asset bids, and competitive devaluations.”

Currency Losses

U.S. technology stocks, as well as gaming and Internet shares in emerging markets, have surged together with the expansion of the Fed’s balance sheet since 2009, the strategists wrote. Property prices in Hong Kong, Indonesia, South Africa, Malaysia, Sydney and London also climbed, they said.

A Bloomberg customized gauge tracking 20 emerging-market currencies fell to 88.94 on Feb. 3, the lowest level since April 2009. The index has tumbled 8.7 percent over the past 12 months.

Among the 24 developing-nation exchange rates tracked by Bloomberg, the Argentine peso, Russian ruble and Colombian peso are the worst performing this year, with respective losses of 16 percent, 6.8 percent and 4.4 percent. In Asia, the South Korean won and the Taiwan dollar are posting the biggest declines of 1.4 percent and 1.1 percent.

The Bloomberg USD Emerging Market Composite Bond Index tumbled to an eight-week low on Jan. 31. A separate gauge tracking local-currency sovereign debt climbed to the highest level in more than three months today. It reached 118.34 on Jan. 31, the least since September.

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