Dollar Strength and Emerging Market Stress are Inseparable
“Fear of floating” is alive and well among EM central banks
The recent strength of the US dollar, which is up about 3.5% in nominal effective terms since late January following a two-year depreciation, is causing investors to re-evaluate their emerging market (EM) exposures. Comparisons with the 1982 Mexican crisis and the 1997 Asian crisis are alarmist and overdone, but faith in better EM macroeconomic and credit fundamentals in support of a view that “this time is different” is equally misplaced. The dollar remains the single most important consideration for EM finances.
If January was, in fact, a dollar inflection point and trend appreciation lies ahead, the outlook for EM sovereigns is likely to be turning decidedly less positive. Chart 1 shows the relationship between the average EM sovereign credit rating from Fitch Ratings and the nominal dollar index. A stronger dollar has been associated with lower sovereign ratings, and vice versa, and turning points have been aligned. There are four primary reasons for this relationship.
First, the most important and well-understood EM issue with a rising dollar is the equal rise in the local-currency cost of servicing dollar-denominated debt. Borrowing in foreign currency on a meaningful scale is almost entirely an EM phenomenon, spurred by the underdevelopment of local capital markets, which is typically associated with low domestic savings, in turn often caused by recent experience with, or lingering memories of, relatively high inflation rates. These conditions are evident in Argentina and Turkey, both of which have been in the cross-hairs of recent market turmoil, although the increase in EM foreign-currency borrowing over the last decade — dominated by the dollar — is much more widespread. Dollar funding has been cheap and plentiful, and EMs have responded accordingly.
The second reason for a strong dollar posing challenges to EMs is the usual inverse correlation between the dollar and commodity prices. With some important exceptions including China, India and Turkey, EMs as a whole are net exporters of commodities. Leaving aside all other considerations with respect to what might drive commodity prices, the dollar price moves inversely with the dollar’s nominal exchange rate. This was apparent most recently in the 2014 commodity price collapse that was mirrored by a strong surge in the dollar.
With oil currently trading at a four-year high, it is clear that the inverse relationship between commodity prices and the dollar does not always hold, but the implications and importance of the dollar as the numeraire currency cannot really be a point of debate. Other factors may cause temporary — or even extended — interruptions in the correlation, but as long as the dollar retains its global pricing role, it will be a driver of commodity prices and the overall EM current account position.
The third issue with respect to a stronger dollar is the ambiguous impact on economic growth. Weaker EM currencies should stimulate net trade and growth in the short term. But medium-term growth is driven more by investment, especially in EMs that need expanded capital stocks to harness the potential economic windfall associated with favourable demographics and rapidly growing labour forces. The overall growth impact will depend on whether the effects of local-currency depreciations are larger on net trade or investment, and the timeframe considered.
The fourth reason why dollar strength is negative for EMs is underappreciated but critically important. Despite the fact that many EM central banks subscribe to floating exchange rate policies, and reassuringly claim that interventions are solely to smooth market fluctuations, it is clear from the correlation between changes in foreign exchange reserves and changes in the value of the dollar that directional dollar movements are persistently resisted in both directions. This may not happen in every EM, since some currencies float more than others, but the data confirm it happens for EMs as a whole (see Chart 2) even after taking account of valuation effects.
In this light, one of the consequences of the fact that the EM “fear of floating”, as articulated by Calvo and Reinhart in 2002, is still alive and well is that a stronger dollar will be associated with a weakening of EM economies’ external balance sheets. EMs together hold about 40% of their external assets as reserves, compared with less than 5% for developed markets. When reserves are depleted to slow local-currency depreciations, it is their single biggest external asset that is being drawn down. Combining the decline in external assets with the increase in local-currency value of dollar-denominated liabilities noted above, EM external balance sheets are hit doubly hard by a stronger dollar.
The view that stronger EM fundamentals will see them through a period of dollar appreciation sounds compelling when reflecting on EM trends that include improved fiscal and current accounts, greater government reliance on local-currency financing, lower rates of inflation and more flexible exchange rates. But “getting the fundamentals right” does not obviate dollar concerns entirely. In fact, exchange rates versus the dollar are very much at the centre of EM fundamentals, and will be for as long as the dollar is the first choice for EM foreign-currency borrowing, the numeraire currency in commodity markets, the leading reserve currency and its exchange rate a prime motivator for EM central bank interventions.