Currencies at mercy of deficits

Turmoil on the world's financial markets could further damage the currencies of countries which rely on capital inflows to fund their spending.

Since the start of the year, growing risk aversion has prompted investors to focus again on economic fundamentals and punish the currencies of countries that have high current account deficits.

The pressure has been particularly severe on debtor emerging market currencies, such as the South African rand and Turkish lira, and those of smaller, open economies that run high deficits like the Icelandic krona.

Paul Mackel at HSBC says currencies such as the rand, lira and krona are vulnerable to another rise in risk aversion such as that following Bear Stearns' rescue.

He says: "These currencies tend to do well when risk appetite is improving. As soon as it loses some of its shine these currencies are picked off quickly".

The South African rand has fallen nearly 18 per cent and the Turkish lira is down almost 6 per cent against the struggling dollar since the start of January.

Meanwhile, Iceland's central bank raised interest rates on Tuesday to try to stem the fall of the Icelandic krona, down more than 20 per cent against the euro since January 1. The bank said the currency's weakness had made it harder for the country to finance its current account deficit.

Other deficit currencies have also been hit, with the Hungarian forint losing 1.8 per cent against the euro so far this year and the Romanian leu falling 5 per cent.

Bilal Hafeez, global head of foreign exchange strategy at Deutsche Bank, says while all eyes are on the funding issues in the credit markets, the currency markets have similar concerns.

Before last summer, risk premiums in the financial markets had been on a clear downward trend since 2003, with volatility on the currency markets falling, risky assets outperforming and cross-border capital flows soaring.

This meant deficit nations found it relatively easy to secure foreign funding. However, since the first signs of the credit crisis emerged last summer, there has been a sharp slowdown in the pace of cross-border capital flows.

Mr Hafeez says the implication for currency markets is clear: "Countries that have large current account deficits require funding for those deficits.

"However, they can no longer rely on readily available cross-border capital flows as before, and so the currency will have to give way and weaken."

Analysts say that as risk aversion increases and becomes a bigger driver of the market, the trend to reward current account surplus currencies relative to current account deficit currencies will intensify.

Themos Fiotakis at Goldman Sachs says: "We have long argued that in times of global turmoil suppliers of capital are poised to outperform countries in need of capital.

"However, it is only since January 2008 that we have seen the current account theme really gain momentum in the FX market."

He says the strong recent performance of surplus currencies such as the Taiwanese dollar, the Malaysian ringgit and the Singapore dollar can be partly linked to this trend, while the underperformance of such currencies as the Turkish lira, the South African rand and the Hungarian forint confirm the theme.

Analysts say this theme has gained traction among leading currencies. The yen and the Swiss franc, which both run healthy current account surpluses, have both risen more than 10 per cent against the dollar so far this year.

Meanwhile, the pound, Australian dollar and New Zealand dollar, which all sport sizeable deficits, dropped sharply as funding issues came to the fore last week as credit markets wobbled.

Mr Mackel said the pound could be vulnerable to the release of UK fourth quarter current account figures this Friday, especially given the fact the deficit hit a 30-year high in the third quarter.

He says: "If the current account disappoints again, the risk premium on holding sterling will rise".