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Emerging market currencies: A well-thought-out crisis

Behold, a selloff in emerging market currencies is at hand. While the story is familiar, markets have turned up the drama; this is no plot twist – the trend hasn't changed, it has only become sharper.

The Turkish Lira and the Argentine Peso have been declining since talk about the Federal Reserve tapering its bond purchases began last May. Now that talk has turned into reality, it's no surprise that these currencies have continued to weaken. The recent moves have been a change only in terms of speed, not direction.

The trigger may have been the announcement of a disappointing Purchasing Managers' Index from China, but that only explains the jump – not the trend.

(Read more: Emerging-market currency 'contagion' spreads)

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Ever since outgoing Fed Chairman Bernanke started talking about tapering last May, the market has been pricing in more difficult times for countries such as Turkey. This can be seen in the graph above, which gives the average performance of the U.S. dollar against 21 emerging market (EM) currencies divided into two groups: nine with current account surpluses and 12 with current account deficits. Note, the ARS is not included because it's such an outlier after last week's devaluation.

The notable point is how the two lines largely moved together until May, when the tapering talk began. From that point on the FX market started to price in the gradual withdrawal of Fed liquidity, a process that has just gotten under way. Although the FX market did begin to discount the Fed move well ahead of time, it's no surprise that it would continue to adjust as liquidity does in fact start to recede.

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Looking at this relationship in more detail may give us some insight into the process and which shoe may drop next. In the graph above, I took 19 of these EM currencies (omitting the SGD and TWD given their double-digit current-account surpluses) and graphed them against the market's forecast for their current account balance this year.

The relatively high correlation in this graph suggests that the impact of tapering has been fairly orderly and well considered, with little knee-jerk contagion. The currencies that have depreciated the most have generally been those with the worst fundamentals, and the degree to which they have depreciated reflects their fundamentals fairly well. There hasn't been an indiscriminate sell-off in EM currencies at all.

The TRY and ZAR have been the worst performing of these currencies, and with good reason. Both countries are suffering from political turmoil while their extremely wide current account deficits need to be funded through capital inflows – a tall order unless investors believe either that the government is taking steps to rectify the situation, as is the case in India, or that assets are so cheap it doesn't really matter. I don't see much resolve by the government to make the sort of fundamental reforms that would attract the international investment community, so I can only imagine that the market will continue to sell these currencies further.

With the TRY now perhaps the most undervalued currency in the world (126 percent undervalued vs USD on a purchasing-power parity basis, according to the OECD) it may eventually reach a point where the market says "enough is enough," but it's hard to say where that would be.

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