Emerging markets currencies are an interesting opportunity for traders, but require greater care than some of the better known major pairs. Normally emerging markets currencies are traded against the US Dollar, for the simple reason that emerging currency / emerging currency pairs suffer from near-zero liquidity. Even when traded against the dollar, low daily volumes are a recurrent issue that will impact your trading strategy from the off. Traders who want to benefit from the opportunities in emerging markets will need an appetite for volatility, strong risk-management processes, and a willingness to be reactive.
Emerging markets
The term ‘emerging market’ is part descriptive term, part euphemism, and applies to a range of economies which often have little in common. When different nations are assumed to be at differing stages on the same growth trajectory, we can talk of emerging markets as those countries which have further to travel to become rich, or those who have not met the economic potential of their natural resources.
Another use of the term describes emerging markets as those economies that had previously seen tight state control of the economy, and were gradually opening up to the outside world. This second use applied to many Eastern European countries in the 1990s, and some South American and African ones since, but in general the term is now used to refer to any economy that is less developed than large middle-income countries such as China, or wealthy ones such as the USA. Exactly when an economy stops ‘emerging’ is difficult to say – especially that the wealthiest economies often also see rapid economic growth.
Generally speaking, emerging market economies are more volatile, have higher average growth (but also higher inflation and more recessions), more political instability, and partly as a result of this instability, more state interference in the economy. For decades going long emerging markets was a winning trade, driven mainly by one ‘emerging market’: China. Nowadays, few traders would consider China, the second richest country in the world by total GDP, and the largest by GDP at purchasing power parity, an ‘emerging’ market. Formerly emerging markets that now rank among rich nations include South Korea and various other Asian economies, and are no longer included in most ‘emerging markets’ indices, though China often is.
Within emerging markets there is huge variety, from tiny struggling states such as Lesotho, countries heavily reliant on natural resources such as South Africa or Russia, large middle-income nations such as Brazil and Mexico, right through to immense continent-sized giants such as India and China. You would be forgiven for thinking there are more logical ways to categorise these economies, and you would be right, except that when it comes to their currencies, they do often behave in similar ways.
Emerging market currencies
Emerging market currencies are those currencies used in emerging markets. As we saw in the section above, emerging markets have very different characteristics, and so do their currencies. There are also a few clear differences between the list of emerging markets and emerging markets currencies; one example is that the Chinese offshore renminbi is a major reserve currency, and so not really an EM currency, though Chinese equities are still regularly included in emerging markets indices.
There is a strong overlap between emerging markets currencies and commodity linked currencies, but the terms are not identical. While BRL, ZAR and RUB are all dual commodity linked, emerging markets currencies, the AUD or NZD are examples of developed markets which still have commodity linked currencies. Some emerging markets currencies do not respond to currency fluctuations, though they are more likely to be than those of developed markets. Likewise, a currency such as the Congolese Franc (CDF), where the currency has lost much of its value over several years, is used alongside the USD to the point where American dollars are accepted as a national currency; despite the commodity-dependence of its national economy, the franc does not trade in a pattern with them and so is not commodity linked.
Emerging markets currencies also differ from the broader category of exotic currencies, which include thinly traded currencies from developed markets such as the HUF. Though a shared lack of liquidity means exotic and emerging markets currencies trade in a similar fashion, the underlying economic status of the economies is quite different and exotic currencies are less prone to political interference or sudden devaluations.
How to trade emerging markets currencies
Once you understand the difference between emerging markets and developed markets and their currencies, you still need to understand how to trade them. The main point to remember is that liquidity is far less available, and the presence of political risks. These combine to create significantly increased volatility, to the point where trades can suddenly jump past stop losses and traditional risk management practice becomes unreliable.
Some understanding of the national economy is essential to trading emerging markets currencies, far more so than for developed markets. Technical strategies that may work on the EUR or JPY are very vulnerable to fundamental-driven price moves in emerging markets, where patterns are often interrupted and trends change without warning. Even trading on fundamental factors can be harder in emerging markets, as official reports of inflation and GDP may be less than reliable. In some currencies, economic data is only sparsely available, and even if you are able to buy them with your broker, this sort of investment is little better than gambling.
For more credible emerging markets currencies the situation is a little different: volumes are lower than for the major pairs, but still considerable, and there is enough continuous liquidity to use technical patterns, though they may be less reliable than in developed markets. Emerging markets currencies linked to middle income countries are good candidates for traders looking to expand out of the main pairs, as they share the desired characteristics of emerging markets (volatility) without some of the worst challenges (unreliable data, political risk). The more volatile a currency, the more opportunities to enter and exit trades for the skilled trader, but of course this comes with an increased risk of trade failure.
Tips for emerging markets
- Not all emerging markets are equal: avoid the most thinly traded and unstable currencies.
- Ensure you understand the economy where the currency is used: if it relies on the export of a single commodity, make sure you know its price history.
- Be prepared for increased volatility, and adjust your risk management practice
If you follow these principles, you should find that the world of emerging markets currencies opens up to you without overly loading your portfolio with risk. As with all trading, leverage will magnify both the gains and losses of your portfolio, and in unstable exotic markets must be used with even greater caution than normal.
How Rakuten can help
Emerging markets offer opportunities that can’t simply be found in the most heavily traded markets. On the other hand, they come with an increased risk, higher volatility, and barriers to market access. If you feel prepared enough to take the plunge, why not open a free demo account and start trading today without risking any of your capital?