What could potentially change for fixed income investors if Brazil, Russia, India, China and South Africa launch a joint Brics currency? Bond managers speak to Piyasi Mitra.
In the next five years, Bloomberg predicts that the Brics countries (acronym for Brazil, Russia, India, China and South Africa) will increase their share of the global economy to nearly 35%, beating the world’s strongest economic conglomerate —the G7 countries (US, Canada, France, Germany, Italy, Japan, UK).
The buzz is that the Brics countries are in talks to launch a new currency soon. The member nations will discuss the feasibility of introducing a new currency at an upcoming South Africa-hosted summit. This drive to reduce dollar-dependence is gaining fillip, with 70% of trade between China and Russia being settled in yuan and roubles now. Janet Yellen, US treasury secretary, also recently admitted that US economic sanctions that are linked to the role of the dollar might over time “undermine the hegemony of the dollar”. Experts estimate fixed income could be impacted by the birth of a new Brics currency.
Challenges galore
Wilfred Wee, co-portfolio manager, China Bond Fund, at Ninety One, thinks this is about Brics nations regaining mastery of their currency by becoming the dominant medium of trade exchange without being “enslaved” to the volatility or cost associated with the US dollar. However, consolidating cross-border trade between large emerging economies in domestic currencies would be a “tall task” without improved payment systems and more flexible movement of domestic capital, says Wee.
Bank for International Settlements data revealed last year that the dollar was the leading currency in foreign exchange markets, accounting for around 90% of global currency transactions. The euro comes second at 31%, and the Chinese renminbi only accounts for about 7% of global foreign exchange turnover.
“If it were to come to fruition, there would be talks about convergence plays — bond yields in more stressed countries benefitting from a single currency.”
The US and EU attract investors into their bond markets due to stable economies that are globally viewed by the majority as a “safe haven”, points out Robert Horrocks, chief investment officer, Matthews Asia.
“For Brics, it must be about capital market and fiscal reforms – not just currency. If it were to come to fruition, there would be talks about convergence plays — bond yields in more stressed countries benefitting from a single currency.”
The resulting fall in interest rates, adds Horrocks, would help holders of these bonds, “probably spurring a real estate boom. However, it would still be hostage to a political union, making such booms transitory”.
Potential opportunities
Sean Neethling, senior portfolio manager Morningstar Investment Management in Cape Town, points out that while oil-exporting countries across the emerging markets have seen more sustainable inflows into their fixed income markets overall, oil importers have seen more volatile flows.
“For commodity exporters like Brazil and South Africa that are reliant on foreign flows to fund current account deficits, this slowdown could affect efficient price discovery in issues denominated in the new currency,” says Neethling. “However, forced buying by locals running anti-money laundering strategies, particularly life insurance companies and banks, as well as pension funds, can be expected to continue supporting issuance in local markets.”
Potential opportunities could include investing with a less volatile local-currency entry point.
“Unhedged allocations are also likely to have a low correlation to the USD [US dollar] and other developed market currencies-denominated debt, which can provide portfolio diversification benefits,” adds Neethling.
“Emerging market local currency yields have historically been priced higher than developed market counterparts. The incremental yield, however, could potentially be lost to hedging costs on the new currency.”
Emerging market investors need to be mindful of the volatility of currency on the individual asset and its correlation and impact on other assets in fixed income and multi-asset portfolios, advises Neethling. “The costs of hedging to uncertainties also need to be considered since this may erode the gains from the asset. Emerging market local currency yields have historically been priced higher than developed market counterparts. The incremental yield, however, could potentially be lost to hedging costs on the new currency.”
Depending on the agreement, central banks of individual countries are likely to compromise their independence to a centralised financial authority. “The spill-over effects of restrictions on using existing policy tools to implement inflation policy could adversely affect price stability, particularly for oil-importing countries. Countries like South Africa and Brazil currently use an inflation-targeting policy that would most likely fall away unless adopted as part of the common currency mandate – a framework that has been particularly useful in managing interest rates in these countries,” adds Neethling.
Drop in the ocean
Echoing similar sentiments, Mara Dobrescu, director of fixed income strategies, Morningstar, points out how Brics funds were fashionable a decade ago, but the asset class has aged poorly. Most funds have now been liquidated or merged, adds Dobrescu.
“Some of the asset managers we’ve spoken to think the dollar’s dominance might get slightly eroded by the yuan,” shares Dobrescu. However, most think of this as “a drop in the ocean”. “The Yuan is still not globally considered safe, convertible and transparent. No other currency in the Brics cohort is a credible candidate either.”
Given China’s disproportionately large share in Brics GDP, the new currency would not make for a well-diversified currency, envisages Robert Simpson, senior investment manager for global emerging market debt portfolios at Pictet Asset Management. A more feasible scenario would be the elevated role of the Chinese currency in global trade, but Simpson argues against the yuan’s heavily managed status. For instance, Chinese companies, banks and individuals must adhere to a “closed” capital account policy that restricts free movement of money into or out of the country without passing foreign exchange laws.
Silver linings
He observes a pick-up in interest by asset allocators looking to gain exposure via emerging market local currency debt strategies that can provide a well-diversified exposure to the broad emerging market currency complex. “Other emerging market assets such as corporate and sovereign credit have also traditionally performed well in such backdrops.”
The Brics currency could shift global investment flows as investors diversify their portfolios, estimates Joseph Mouawad, a bond investment manager at Carmignac. “Depending on various factors, if it offers higher returns than its counterparts in developed economies, it could attract a greater share of fixed income investment capital,” says Mouawad.
“The Yuan is still not globally considered safe, convertible and transparent. No other currency in the Brics cohort is a credible candidate either.”
The currency could spike demand for sovereign bonds issued by the Brics countries, points Mouawad. As an outcome, increased competition for government bonds issued by developed economies could potentially shift global investment flows. For instance, a company with significant revenue-generating business operations in a Brics country could potentially benefit from the new currency.
“EM [emerging market] bonds could benefit from a new Brics currency if it increases demand for EM debt – depending on the performance of the economies, as well as competition from other emerging economies,” adds Mouawad.
Subject to the creditworthiness of issuers, high-yield bonds could also benefit from increased demand if the new currency offers higher returns than its counterparts in developed economies, Mouawad explains.
The challenges outweigh the opportunities, but the emerging signs of a dollar alternative cannot be ignored. For now, there’s no dethroning the dollar anytime soon. As ex-US treasury secretary, Lawrence Summers, remarked on the topic of what might dethrone the $: “You can’t replace something with nothing — Europe is a museum; Japan is a nursing home, and China is a jail.”
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