3 things to watch in emerging market currencies

3 things to watch in emerging market currencies

The US dollar has been on a tear since July, and its effect are beginning to hit emerging markets.

First there was the taper tantrum, then another, then another. Emerging markets have been extremely volatile as markets feel out how the Federal Reserve will normalize monetary policy in the US. Now, a new source of volatility is emerging: a strong US dollar.

This, of course, has quite a bit to do with the end of quantitative easing in October, but it also has to do with brightening US economic indicators. As this trend continues, emerging markets will have to deal with sliding currencies. How they manage this could dictate how they grow in the coming years.

Central bank intervention

After the Federal Reserve began winding down its quantitative easing program at the beginning of 2014, emerging markets experienced an unprecedented level of capital outflow. In January, investors pulled $12 billion from emerging market equity and bond funds. To counteract that outflow, Turkey’s central bank surprised markets by raising interest rates to 8.0%, from 7.75%.

Turkey’s surprise move worked the way it had hoped. The Turkish lira jumped against the US dollar and continued strengthening for five months. Part of the surprise was the novelty of the move, but just as much of it came from how counterintuitive the action was. The central bank playbook says to respond to a slowing economy by lowering rates. Turkey recognized that its slowdown was unconventional, so its actions needed to look different as well.

Turkey’s addition to the central bank playbook attempts to convince investors to keep their capital in emerging markets by sweetening the carry trade, and other emerging market central banks must have taken notice. As the Federal Reserve ends quantitative easing this month and US job growth accelerates, the US dollar will continue strengthening – after already rising 7% against a basket of other currencies since July.

Facing this trend, emerging market central banks will entertain the Turkish response to their falling currencies. Several of the other of the ‘fragile five’ economies – South Africa, Brazil and Indonesia – are candidates to follow this path.

While Turkey’s results look promising to its peers, there will be increasing costs for central banks to take that route. The surprise factor, which played a significant part in Turkey’s action, will dissipate with each time an emerging market central bank raises rates to counteract capital outflows and falling exchange rates.

Beyond that, this action is fundamentally a trade-off between domestic and foreign interests. Raising rates will slow down the domestic economy, even as it minimizes capital outflows. For large economies that depend heavily on foreign direct investment (like Chile), this will be an easier trade-off to make.

Trade balance

Two signs point to the US importing more goods in the next year: a stronger dollar and accelerating job growth. While emerging market currencies are taking a hit from these trends, exports from emerging markets should increase.

Corporate profits

Despite US economic growth, the fastest growing business segment for S&P500 companies is beyond American borders. More than one-third of these companies’ revenue comes from foreign sources. For tech companies, the share is even higher, at 57%. Since all of these companies’ profits are ultimately in US dollars, falling exchange rates in emerging markets will shave down profits from their fastest growing markets and cut into earnings.

Since China is the biggest and fastest growing market for many sectors, the tightly controlled renminbi will limit this effect. Other emerging markets, however, will not provide this luxury, especially since the World Bank has discouraged managed exchange rates since the Asian Financial Crisis in the late 1990s. Latin American countries and Russia have already contributed to shrinking corporate profits, as evidenced by Ford’s second quarter earnings. With earnings season just a couple weeks away, expect the appreciating US dollar to feature prominently.

How emerging market monetary authorities manage the strengthening dollar will have a major effect on how these economies perform in the short term. The most prominent risk, however, is that overly short-sighted policies will cause harm that will outlast the effects of their sliding currencies.

Categories: Economics, International

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, Oilprice.com & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.