Emerging currencies set for biggest underperformance in more than a decade

LONDON (Reuters) - The performance gap between emerging market currencies and their developed peers has blown out to its widest level in more than a decade as falling interest rates, an uncertain economic outlook and sizeable outflows curb investor appetite.

A group of 10 major emerging currencies - including the Chinese yuan, the Brazilian real and the Turkish lira - have underperformed developed market currencies by nearly 14% this year, according to Nordea Research.

Graphic: EM FX and developed FX https://fingfx.thomsonreuters.com/gfx/mkt/nmovaymbdva/EM%20FX%20and%20developed%20FX.JPG

That is in stark contrast to the aftermath of the 2008/09 global financial crisis when the same basket of currencies gained as much as 25% thanks to massive fiscal stimulus from China, which in turn boosted global growth and commodity prices and helped countries from Indonesia to Brazil recover quickly.

"A lot of people expected emerging markets to strengthen strongly...but that hasn't happened this time as the carry story has virtually disappeared and we are also not seeing dramatic growth outperformance," said James Binny, global head of currency at State Street Global Advisors.

Relatively higher interest rates in emerging markets have always been a big draw for investors, but now central banks are being forced to do the heavy lifting to support their struggling economies, and policy makers - in the absence of meaningful inflation pressures - are far more tolerant of currency weakness than in the past.

Emerging central banks have now cut interest rates for 20 consecutive months.

Graphic: EM central banks https://fingfx.thomsonreuters.com/gfx/mkt/rlgpdxmbdpo/EM%20central%20banks.JPG

There are signs the easing cycle may be running out of steam with the speed of rate cuts slowing and Turkey and Hungary surprising with rate hikes. Yet that offers little solace to foreign investors who made a beeline to emerging markets in recent years.

Foreign investor holdings of major emerging market local currency debt has fallen sharply to near $400 billion from $550 billion at the start of the year, TS Lombard data shows.

While some of the decline has been offset by investors piling into Chinese local bonds ahead of the country's inclusion in the global bond benchmark WGBI next year, dismal growth prospects mean outflows from emerging markets remain large.

Even by the end of 2022, the economies of Brazil, Mexico and Turkey are likely to be around a tenth smaller than pre-virus estimates, according to forecasts by Capital Economics.

Graphic: Performance of EM vs DM https://fingfx.thomsonreuters.com/gfx/mkt/ygdvznreevw/performance%20of%20EM%20vs%20DM.JPG

(Reporting by Saikat Chatterjee; Editing by Karin Strohecker and Kirsten Donovan)

By Saikat Chatterjee