The Dollar Trouble: Emerging Markets Count the Costs

U.S. one-dollar bills are seen in front of the stock chart shown in this illustration taken on February 8, 2021. REUTERS/Dado Ruvic/Illustration

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LONDON, May 11 (Reuters) – Barely recovered from a two-year COVID outbreak, emerging markets now face capital flight, inflation and even debt defaults as the dollar’s run to two-decade highs tightens the screws.

Almost all past emerging market crises were linked to the strength of the dollar. As the dollar rises, developing countries must tighten monetary policy to prevent declines in their own currencies. Failure to do so would exacerbate inflation and raise the cost of servicing dollar-denominated debt.

Despite all the improvements of the last few decades, those equations still hold broadly, and the dollar’s recent rally is leaving a trail of destruction in its wake.

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Soaring commodity prices are another complication, along with the decline of the Chinese yuan, an anchor for Asian and commodity currencies.

“The cracks are widening. When a strong dollar meets high commodity prices, it’s not uncommon for us to run into trouble in emerging markets,” said Manik Narain, director of emerging markets strategy at UBS.

“And when the yuan weakens, there are no winners in emerging markets.”

coin enigma

The dollar’s appreciation has pushed the emerging currency index down 3.5% this year to an 18-month low (.MIEM00000CUS), though that hides larger 9%-15% losses in currencies such as the Polish zloty and the Turkish lira. Losses also widened in April, coinciding with the decline in the yuan.

Flexible exchange rates protect developing economies against a repeat of the crises of the 1990s.

Back then, a surge in US currency and Treasury yields first sparked Mexico’s ‘Tequila’ crisis in 1994, then sent shock waves through Asia, Russia and Brazil as dollar parities they collapsed one by one.

But a stronger dollar still means higher imported inflation, especially given the 30% to 40% increases in food and oil prices. Currency declines also likely helped precipitate recent strong investment outflows from emerging markets. Read more.

As recession concerns spread across global markets, the shine is coming off this year’s bright spot: commodity-exporting Latin America. Chile’s peso, which relies on copper, gained 8% in the first quarter, only to fall 10% since then.

Emerging currencies suffer the pain of the dollar

GROWING PAINS

Central banks across the developing world have raised interest rates by hundreds of basis points cumulatively to control inflation and ensure enough of an inflation-adjusted bond premium for rising US yields.

As a result, emerging economies may expand just 4.6% this year, the World Bank forecasts, compared with a previous prediction of 6.3%.

A strong dollar may also slow growth as it tightens financial conditions, an indicator of how easy it is to get credit. A Goldman Sachs emerging markets financial conditions index is close to the tightest since 2008, up about 300 bps this year.

PMIs signal a slowdown

DEATH OF THE DEBT

Rising Treasury yields mean a higher cost of capital globally, but it’s especially painful for countries that have gorged themselves on dollar loans.

In JPMorgan’s EMBIGD Emerging Dollar Sovereign Bond Index, yields have risen above 7%.

Rising debt costs, coupled with economic mismanagement and political unrest, have combined to propel Sri Lanka into full-blown crisis, and the same scenario could repeat itself elsewhere, investors fear.

Higher borrowing rates are also deterring many emerging market governments and companies from taking advantage of international bond markets. April, usually a busy month for new bond issuance, this year saw its issuance since 2015, with sales of just $6.9 billion.

However, Trang Nguyen, emerging markets strategist at JPMorgan, forecast that bond sales would rise, “even if this has to come at a higher cost, as countries will eventually need to close their funding gaps.”

Border markets feel the heat

INFLATION STATIONS

The strength of the dollar and the weakness of the national currency translate into higher import bills and, therefore, into an acceleration of inflation.

Although emerging markets began their tightening cycles much earlier than their developed peers, inflation has consistently outperformed expectations.

The rates are dazzling: annual inflation in Argentina exceeds 50%, in Turkey 70%. Even the richest emerging economies, like Hungary, are experiencing double-digit inflation.

The International Monetary Fund expects inflation to average 8.7% in emerging markets this year, some 2.8 percentage points higher than projected in January.

Turkey, Tunisia, Egypt, Ghana and Kenya are among the countries seen at risk due to hard currency debt burdens, current account deficits and heavy reliance on food and energy imports.

“Commodity prices are a key axis of vulnerability and if we see a renewed surge in oil and food, we may see a growing list (of casualties),” said UBS’s Narain.

Emerging market inflation surprises on the upside
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Reporting by Sujata Rao and Karin Strohecker Editing by Tomasz Janowski

Our standards: the Thomson Reuters Trust Principles.

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