What next for “frontier” currencies?

By Jason Tuvey, Assistant Economist Capital  Economics

“Frontier” currencies have been the hardest hit in the latest bout of EM financial market turmoil.
Looking ahead, we think further exchange rate weakness is likely to be concentrated in those
countries that have already seen the sharpest falls – Argentina, Ukraine and Ghana. But a weakening

Nigeria's CBN Gov, Sanusi

of oil prices and falling FX reserves could force the Nigerian authorities to devalue the naira.
Until recently, “frontier market” currencies had come through the numerous bouts of EM turmoil over
the past year relatively unscathed. This is largely due to the fact that central banks in most of these
countries have kept a tight grip on the exchange rate.
However, as Chart 1 shows, most “frontier” currencies have fallen against the dollar since the start of
this year. (This chart shows all the “frontier markets”, as defined by MSCI. Many of these are covered on
our regional EM services and we would direct our readers there for more detailed analysis.) Central
banks in Argentina and Kazakhstan have devalued their currencies by over 15%, while Ukraine’s
central bank has loosened its grip on the hyrvnia. The Ghanaian cedi has also weakened substantially.
This has inevitably raised the question of whether other “frontier” currencies might be vulnerable.
One measure of external vulnerability is the gross external financing requirement, which incorporates
both current account and external debt positions. By comparing this to FX reserves, we can get a sense
of how much firepower central banks have to support the currency. Faced with weaker capital inflows,
the authorities have the choice of either letting the currency weaken or selling some of their FX reserves.
Clearly, if FX reserves are low compared to external financing needs, then it is more likely that the
currency will have to weaken.
This would seem to be a pretty good predictor of currency weakness in Ukraine, Ghana, Argentina and
Kazakhstan. (See Chart 2.) And, on this basis, there are several other “frontier” currencies that would
appear vulnerable to a slowdown in capital inflows, including Sri Lanka, Tunisia, Lebanon, Lithuania,
Pakistan and Jamaica.
Of course, this is no cast iron rule and it’s important to differentiate between “frontier markets”. In
particular, there are other factors at play that mean these countries may avoid sharp falls in their
currencies. Tunisia, Jamaica and Pakistan have IMF backstops in place, while Sri Lanka would probably
return to the Fund if external pressures mounted. Meanwhile, Lebanon should receive a drip-feed of aid
from the Gulf while Lithuania is in advanced preparations to join the euro at the start of 2015.
Equally, there are some country-specific factors that need to be considered. For example, Nigeria has
low external financing needs, but persistent capital flight has led to strains in the balance of payments.
This has forced the authorities to run down FX reserves to protect the value of the currency. But if oil
prices fall, as we expect, a sharper adjustment of the naira may be needed. (For more, see our Africa
Economics Focus, “Nigeria: naira devaluation on the cards”, 9th August 2013.)
Given all this, we suspect that countries that have already experienced sharp falls in their currencies
are still the most vulnerable to further exchange rate weakness. Indeed, we have pencilled in further
falls in the Argentine peso, Ukranian hyrvnia and Ghanaian cedi.

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