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The Myth of EM FX pass-through

The Emerging View

14 March 2017

One of the common perceptions about EM is that inflation rises sharply when their currencies weaken. This is because weaker currencies allegedly push up the domestic prices of imported goods and services, which make up part of CPI indices. This phenomenon has a name: FX pass-through. Yet, currency weakness can equally be deflationary. Outflows can weaken economic growth and inflation, for example, turning the conventional thesis of FX pass-through on its head. Given this theoretical ambiguity, what does the data show? Did the 43% depreciation of EM currencies between 2010 and 2015 cause inflation rates to rise in EM? The answer is no. EM inflation declined. There is also compelling evidence that stronger currencies have been associated with higher inflation. The fact that FX pass-through is a myth implies that investors should have permanent allocations to EM local currency bonds. Looking forward, we expect flows to EM to pick up. This should also push EM inflation moderately higher, which means that EM carry will remain attractive. We quantify the likely source of return in EM local bonds over the next five years and find that currencies are likely to make significant contributions to total return.

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