U.S Dollar Storm Rolling Over Emerging Markets

Emerging markets depend on foreign capital and international investments, both of which weaken as the U.S dollar appreciates.

The rise of the U.S. dollar to multi-decade highs is damaging emerging market economies that are being hit by the Federal Reserve’s most ferocious tightening cycle in more than a generation. This is because the safe haven currency drives down rival currencies, increasing the cost of imports, tightening financial conditions, and fueling inflation in these economies.

The strong greenback is pushing the value of emerging market currencies like the Turkish Lira, South African Rand, and Polish złoty down, increasing the cost of imported products, tightening financial conditions, and fueling inflation in other economies.

The potential of a wave of defaults across the world’s most fragile economies is increasing as emerging markets use foreign currency reserves at the quickest rate since 2008.

According to figures from the International Monetary Fund, the foreign reserves of emerging and developing countries have decreased by $379 billion so far this year, through June.

This influence of higher or lower US interest rates on capital flows to developing nations is typically thought to be the cause of this cycle. This is due to the Federal Reserve’s very aggressive tightening cycle.

First off, a rising dollar tends to slow down the expansion of world trade. A sizable portion of international commercial transactions is settled and invoiced primarily in this currency. A stronger dollar tends to make the globe poorer and less trade-engaged because non-US currencies lose purchasing power as the dollar appreciates.

In addition, the US dollar is a global currency used for international trade, which accounts for about 40% of the $28.5 trillion global trade every year. The trade-weighted dollar index measured by the Fed against advanced economies has increased 13% this year, reaching its highest level since 2002.

Against the dollar, Ghana’s cedi has suffered its biggest loss this year amid uncertainty surrounding a potential debt restructuring. In addition, some of the worst-performing currencies in the world this year come from emerging markets that also include Turkey and Argentina.

Other peers, however, have benefited from the superior performance of currencies backed by commodities, like the Brazilian real and the Russian ruble.

An increase in the price of food imports triggered by the strong dollar and widening poverty; caused a debt default and the overthrow of a government in Sri Lanka, as well as inflicting losses on stock and bond investors in financial centers all over the world.

India has reached out to trading partners, including Saudi Arabia, Russia, and the UAE, to switch transactions to local currencies as a result of the pressure from the high dollar. This year, the rupee’s decline against the dollar has been around 11%.

The rallying dollar tends to make developing nations with debt denominated in US dollars less creditworthy. The cost for nations to purchase the US currency they require to pay their debts rises as a result of the strengthening dollar.

For lower-income nations, who often only have a circumscribed ability to borrow internationally in their own currencies even during the best of times, this is probably going to be a most unpleasant situation.

The performance of emerging-market bonds has also been among the worst in the fixed-income universe over the past year. As EM bond yields rise, there may be some opportunities in the long run, but in a tightening Fed policy environment, shrinking global liquidity, and a rising dollar, EM bond returns are not favorable.

Foreign investors have pulled money out of emerging markets for five straight months, the longest streak of withdrawals ever, according to data from the Institute of International Finance (per this Financial Times article). This is vital investment capital that is flying out of emerging markets towards safety.

Greater oil consumers like China and India have all experienced fewer real-term drops in crude prices than would be predicted by benchmarks Asian nations have experienced comparable suffering. Despite total volumes being lower as the nation struggles with limitations to stop the spread of Covid-19, the value of China’s oil imports through August was up 50% from a year earlier.

In addition, for some emerging nations such as Sri Lanka, the effects of rising oil prices and depreciating currencies have already manifested as a nearly complete economic collapse.

For the majority of emerging nations to finance their fiscal account deficits, foreign inflows are crucial. In search of stronger investment returns, capital may flow away from emerging markets and back toward the United States if U.S interest rates rise.

The higher dollar now is probably more likely to cause inflation in emerging economies than it was in the past. Recent years have made it possible for us to overlook how swiftly inflation can result from currency depreciation in a developing nation.

This is due to the fact that in recent years, the so-called transit from the exchange rate to inflation has, in fact, tended to be quite low.

The greenback is in high demand, which is why they are gaining value. The majority of economies’ economic outlooks indicate a significant decline. Meanwhile, geopolitical risk and volatility in the markets have increased due to the conflict in Ukraine.

Additionally, the US Federal Reserve has rapidly raised rates as a result of historically high inflation. These and other factors are causing a flight to safety, where investors are selling their positions in Europe, emerging markets, and other places in search of safety in US-denominated assets, which must clearly be purchased with dollars.

Many nations, particularly the poorest, are unable to borrow in their own currencies at the levels or for the durations they desire. Lenders do not want to take the chance of receiving repayment in the unstable currencies of these debtors. Instead, these nations typically promise to repay their obligations in dollars, regardless of the exchange rate, when they borrow money.

As a result, these repayments become significantly more expensive in terms of native currency as the dollar gains strength in relation to other currencies. This is referred to as the “first sin” in terms of governmental debt.

A strong dollar impacts them from a domestic perspective, including spiking inflation because many developing economies are price-takers (their policies and actions do not affect global markets).

Increasing dollar strength makes imports more expensive (in domestic currency terms), which forces firms to reduce investment or spend more on important imports.

Some long-term trade prospects are better than others, but overall it’s a mixed bag. Despite a strong dollar, imports are more expensive for foreign buyers, but exports are relatively cheaper. Increased exports can help boost GDP growth and foreign reserves in export-driven economies, which alleviates many of the issues discussed here.

Easing the Pain

Who, then, is doing better? Brazil has done rather well recently, and among East Asian nations, the percentage of debt denominated in dollars is relatively low. The latter has benefited from the enormous dollar holdings of the central bank, the fact that it is a net commodity exporter, and the fact that the private sector appears to have done well to protect itself from currency swings. Short-term solutions to these problems are limited for countries. The best approach is to deal with these issues preemptively rather than reactively. To prevent the next crisis, countries should act now to shore up their financial position and engage in sustainable borrowing. Even in challenging times, policymakers can find opportunities to encourage investment and spur economic growth while reducing fiscal pressures.

For its part, the international community must do more to speed up debt restructuring. Putting countries back on a more sustainable fiscal path will be a huge help.

Global economic conditions are becoming increasingly hostile for developing countries: rising recession risks in the west, a slowdown in China; more risk-averse investors, decreasing funding availability and increasing funding costs, accelerating inflation almost everywhere, and growing concerns about food availability.

Forecasts for the US currency

With so many unknowns, central banks from Argentina to Nigeria are forced to imitate the US and hike borrowing prices in order to fight inflation. The likelihood of further rate increases is increasing each week. Few investors worldwide are currently willing to bet against the dollar since there is still a lack of information on when the cycle may stop.

The continual strength of the dollar appears particularly likely in the near term given the Fed’s substantial rate hikes at a time when policy rates in the eurozone and Japan remain close to zero. This should boost demand for higher-yielding, dollar-denominated securities.

It is anticipated that the greenback will remain relatively strong this quarter before gradually declining next year as tighter Federal Reserve policies cool an overheating economy.

This content is for educational purposes only. It does not constitute trading advice. Past performance does not indicate future results. Do not invest more than you can afford to lose. The author of this article may hold assets mentioned in the piece.

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