A strong U.S. dollar and high Treasury yields pose significant challenges for emerging economies, and policymakers don’t have an easy way to counter this powerful duo.
With American exceptionalism casting a shadow over the rest of the world, many emerging markets are facing a depreciation of their currencies, an increase in the cost of servicing dollar-denominated debt, a decrease in capital flows, and even capital flight, falling local asset prices and slowing growth.
Added to this is the uncertainty and nervousness surrounding the new US government’s proposals for tariffs and trade policies.
History has shown that when such trends take hold in emerging markets, they can create vicious cycles that accelerate quickly and prove difficult to break.
Unfortunately, there doesn’t seem to be a simple road map to avoid this.
Just look at China and Brazil.
The monetary and fiscal paths followed by these two emerging market heavyweights could not be more different. Beijing commits to easing its monetary and budgetary policy to revive its economy; Brasilia promises significantly higher interest rates and seeks to put its public finances in order.
Their divergent trajectories – and their continued struggles – suggest that regardless of where emerging economies fare in terms of growth, inflation and fiscal health, they are likely to face a difficult road ahead in the years to come.
FOLLOW THE MOVEMENT
Brazil and China are clearly in very different situations, especially when it comes to inflation. Brazil has a lot of them, prompting the central bank to take aggressive action and provide guidance. China, meanwhile, is battling deflation and is finally starting to cut interest rates.
Another difference lies in the fiscal space each country has to generate growth. Brazil’s reluctance to cut spending enough is a major cause of the real’s collapse and dramatic central bank tightening. The market forces Brasilia’s hand.
The market is also putting pressure on Beijing, but in the opposite direction. All the support plans and measures announced since September to revive economic activity amount to thousands of billions of dollars.
But while the tactics of the two countries are diametrically opposed, the results so far have been similar: sluggish growth and weak currencies, a picture that most emerging countries recognize. The Brazilian real has never been weaker and the tightly managed yuan is near the lows it last reached 17 years ago.
As Reuters exclusively reported, China is mulling whether to let the yuan weaken in response to looming U.S. tariffs, and analysts at Capital Economics warn the yuan could fall as low as 8.00 per cent. dollar.
But letting the yuan depreciate is not without risk. This could accelerate capital outflows and trigger currency devaluations across Asia and beyond.
A race to the bottom of emerging market currencies would be very problematic for the countries concerned, because, according to the Bank for International Settlements, the dollar is now a more important driver of emerging market capital flows than interest rate differentials . State Street analysts estimate that exchange rates explain about 80% of local sovereign debt yields in emerging countries.
The Institute of International Finance estimates that capital flows to emerging countries will decline next year, from $944 billion this year to $716 billion, a drop of 24%.
“Our forecasts are based on a base case scenario, but significant downside risks remain,” the IIF said.
FINANCIAL CONDITIONS ARE TIGHTENING
Emerging countries are also facing rising US bond yields.
Although the stock of hard currency sovereign and corporate debt is small relative to that of local currency debt, it is increasing. Total emerging market debt is now approaching $30 trillion, or about 28% of the global bond market. This figure was 2% in 2000.
The pressure from rising borrowing costs is being felt in due time. According to Goldman Sachs, financial conditions in emerging markets have been at their tightest in almost five months, with the rise in recent months almost entirely due to rising interest rates.
Real interest rates are much higher today than they were during Trump’s first presidency. But many countries may still struggle to reduce them, as this “could create financial stability problems by putting pressure on exchange rates”, JP Morgan analysts warn.
The positive point is that emerging countries have substantial foreign exchange reserves on which they can rely, in particular China. Most of the 12.3 trillion dollars in global foreign exchange reserves are held by emerging countries, including 3.3 trillion dollars by China alone.
Caught between a rock and a hard place, policymakers in emerging countries could soon be forced to draw on these reserves.
(The opinions expressed here are those of the author, a columnist for Reuters).
