Investors have been selling so-called ‘risk assets’ in recent weeks on fears that Greece may have to leave the 17-nation euro bloc after talks to form a new government broke down. After several days of selling, risk assets stabilized on Thursday. The Indian rupee - one of the worst affected currencies this year - strengthened against the U.S. dollar.
But David Roche, Global Strategist at Independent Strategy, a London-based research firm, sees emerging market currencies weakening further as these economies post disappointing growth, putting pressure on their central banks not to raise rates in the face of higher inflation.
Higher inflation and lower real interest rates could make these countries less attractive to foreign investors. Since many emerging markets depend on inflows of capital to fund their current account deficits, Roche foresees a "funding gap" developing.
On Wednesday, for example, the Indian rupee dropped to a fresh all-time low of 54.44 against the U.S. dollar. The country runs a current account deficit of 4 percent of GDP, making it especially vulnerable.
It’s not just Asian currencies that have been tumbling in recent weeks. South Africa’s rand plumbed five month lows against the dollar on heightened global risk aversion on Wednesday before staging a recovery in late afternoon trade. Brazil’s real broke through 2.0 against the dollar earlier this week before snapping back to 1.9976.
Sebastien Galy, Societe Generale’s Senior Currency Strategist, agrees that emerging market currencies, especially the rupiah, won, and rupee, are likely to weaken further as retail investors also start selling their holdings.
"While hedge funds and to a lesser amount asset allocators have already bailed out, retail has not," Galy said. "Our emerging-market colleagues survey shows that only 10 percent of professional investors are now bullish on emerging markets. The crisis is starting to intensify, reaching the level of contagion as it feeds on itself."
Time to Buy?
However, analysts also say the recent weakness could create buying opportunities as central banks step in to support local currencies.
"We like to buy the rupee, rupiah and the Malaysian dollar on dips and to a lesser extent the South Korean won," Daly said. "Central banks have started to try and stem some of the outflows. India was the most active but we are seeing some catch up."
After the recent selloff, some currencies are undervalued, oversold and offer attractive carry, Nicholas Ferres, Investment Director, Global Asset Allocation at Eastspring Investments said.
"The countries with the most attractive relative interest rates (carry) are Turkey, India, South Africa, Indonesia and Mexico," he told CNBC. "Of those, India and Mexico are also modestly undervalued on a real effective exchange rate basis. The Korean won is also undervalued and offers decent carry."
Ferres said investors should avoid commodity currencies, as well as the Turkish lira and the Indian rupee but he may look at the Indonesian rupiah because it is "cheap".
When macroeconomic conditions and risk appetite stabilize, it will be time to buy, he added.