Large current account deficits in developed countries are creating imbalances on exchange rates, the bank said in a report published Thursday. The remaining global imbalances are offset by current account surpluses in some of the main emerging market economies where exchange rates remain undervalued, analysts Daniel Tenengauzer and Parag Ramaiya wrote in the report.
Considering its valuation model, the bank is recommending a long position on a basket of Brazil's real, the Russian ruble and Norway's krone. A long position is a bet on a currency's gain.
"In addition to the attractive valuation, we find this basket dominates other alternatives in terms of risk-adjusted returns and accounting for carry trade," the analysts wrote. Carry trade refers to borrowing currencies in nations with low interest rates and buying higher-yielding assets elsewhere.
They said the fair value for Brazil's real would be 1.54 reais per dollar, using a model that considers structured current account positions and capital flows. That compares with a spot rate of 2.0815 reais per dollar. The Russian ruble's fair value is 15 per dollar, compared with a spot rate of 26.2225 rubles to the dollar.
The imbalance for each country is the difference between the structural and medium-term current account, the bank said.
"The equilibrium exchange rate is that which causes the difference between the two to be zero," the analysts wrote in the report.
Merrill said a current account deficit or surplus is not what determines the valuation of exchange rates.
"What really matters is whether current account positions are too large or too small," the report said. "It is possible to be bearish on currencies of countries with current account surpluses and bullish on currencies with deficits."
The bank said undervalued currencies are in Argentina, Brazil, Chile, China, Hungary, South Korea, Malaysia, Mexico, Poland, Russia and Singapore. The other five currencies Merrill evaluated are overvalued by an average of 12 percent. They are in India, South Africa, Taiwan, Thailand and Turkey.
