Emerging market (EM) foreign exchange rates have been hit hard by the global market sell-off on the back of the coronavirus pandemic, but for the major floating currencies, this could also provide a path to recovery, according to some analysts. The surge to the U.S. dollar given its perceived safe-haven status has driven several EM currencies to record lows against the greenback in recent weeks, such as the South African rand, Mexican peso and Brazilian real. The rand closed out last week down 32% against the dollar over the past three months, while the peso was down 24% and the real was 23% lower. The impact of the flight from risk assets amid the outbreak was compounded for emerging markets by cratering oil prices, as the virus weighed on demand and a standoff between Russia and Saudi Arabia over production cuts also pushed prices lower.

Many emerging market economies are heavily reliant on oil and commodity exports, while others suffer knock-on impacts as a result of regional trade links, meaning emerging market currencies and risk assets broadly correlate with the performance of oil and commodity prices. Oil prices stabilized over the weekend after OPEC and its allies reached an agreement on production cuts, but EM currencies still face unprecedented pressure until an end to the pandemic comes into view.

'Escape vaults'

Investors are trying to gauge the bottom for EM assets amid the pandemic, while also monitoring monetary and fiscal policy responses from governments and central banks. The effects of the crisis on capital and economic growth projections also suggest further downward pressure, and mean EM foreign exchange will likely remain the weakest link in the short term, according to Citi Head of CEEMEA Strategy Luis Costa. However, as strong shocks are felt on both external and domestic fronts, floating emerging market currencies — those which are set by the foreign exchange market rather than government, and allowed to fluctuate accordingly — will continue to respond by acting as "dynamic stabilizers," Costa highlighted in a note last week. As central banks around the world scramble to ease monetary policy, EM policymakers could allow their currency to depreciate on a real basis (i.e., the depreciation achieved over the inflation measured in the period), providing an effective way to ease their domestic monetary conditions, Citi analysts suggested.

"They will use the effects as a way to absorb market shocks, meaning as a policymaker, what is the use of trying to prevent my currency from weakening further if this is exactly what I need at a domestic level?" Costa told CNBC via telephone on Thursday. "Looking into the big floating currencies, like the South African rand, the Brazilian real, the Mexican peso, the Korean won, it's good because they are going to be escape vaults to some emerging economies to absorb the devaluations of growth." Central bankers and finance ministers in emerging market countries have voiced similar outlooks, with the South African Reserve Bank (SARB) thus far resisting intervening in the rand and instead launching a substantial bond purchase program. "Some central banks are not necessarily in this line, which is probably the case for some central European central banks, but if you take the vast majority of EM central banks, they have been, in a way, taking the chain and seeing that as long as it's not a currency run - and I don't think we have seen currency runs yet, even though the losses have been in double-digit levels - I do believe this is going to be a natural way for economies to react."

'Undervaluation' levels

Goldman Sachs currency analysts have compared current EM FX valuations to those that prevailed after both "moderate" sell-offs — such as those in September 2018 and January 2016 — and "severe" sell-offs — in the wake of the global financial crisis in 2008 and after each individual EM currency reached its cheapest level of the past ﬁve years. "Taking into account the rally of the past week, the median EM currency is currently approximately 9% undervalued, which implies that it has passed 'moderate' levels of undervaluation, and would need to depreciate approximately 3%-4% to reach 'severe' levels of undervaluation," Goldman Sachs Co-Head of Global Foreign Exchange, Zach Pandl, said in a note Monday.