The news this week in currency markets centered on emerging market (EM) currencies' weakness and the worry over whether it could lead to global contagion.
The basis for EM currency weakness stems from the fact that U.S. monetary policy is diverging from the rest of the world.
The U.S. Federal Reserve is on pace to raise rates faster than other countries. This narrowing interest rate difference incentivizes international investors to put their money back into U.S. dollars, resulting in loss of value for EM currencies.
Another stress on EM currencies is increased levels of debt service. EM countries typically run current account deficits and are highly leveraged with U.S. dollar-denominated debt because their currencies are not liquid. Each time the Fed raises interest rates and the dollar strengthens, their repayment costs go up.
The International Monetary Fund (IMF) had provided ample macroeconomic guidelines to these EM countries to avoid such crises, such as keeping a minimum amount of foreign exchange reserves and setting inflation targets and exchange rate regimes. So we thought that an EM contagion would not happen.
But let's take a look at what's happening now.
The recent crisis started with the Argentine Peso (ARS) a couple of months ago. Running a large current account deficit funded with U.S. dollar borrowings, President Mauricio Macri successfully secured a line from the IMF. The market was not satisfied with that because it comes with an austerity package that could erode Macri's future popularity, especially as he faces a presidential election next year, and a new leader might not be able to successfully secure much-needed IMF funding.
Then there's Turkey. President Recep Tayyip Erdogan has taken over much of the central bank's role in his country and he failed to raise interest rates in the deeply inflationary environment that Turkey faces. Once again, investors decided that Turkey is self-inflicting problems through politics and money fled out.
In India, the Indian Rupee (INR) is the worst-performing currency this year, although the country is the third-largest economy in the region. With India's current account deficit widening to its largest point in five years and oil prices elevated, investors are worried that rising U.S.-China trade tensions could affect India. The Reserve Bank of India (RBI) has not been keen on raising rates and hence investors are more attracted to the dollar.
Finally this week, South Africa's currency dropped, which was more unexpected. With two consecutive negative GDP growth rates, the country has fallen into a recession. Its central bank was able to lower rates last March and the lack of the interest yield shine resulted in their currency fall.
Our View: A major cause of this EM crisis has shifted from economic to political risks. This factor is hard to quantify and leaves investors with a lot of uncertainty. Trade frictions could change the outcome of the trade imbalances of each nation. Election outcomes could lead to social unrest. Until all these uncertainties subside, the wobbly EM currency outlook is likely to persist.
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