Strong dollar throws up challenges
by Anna Stupnytska
After years of exceptional performance, emerging economies have disappointed since the start of the current decade. Growth has slowed sharply, and not just in absolute terms. The relative growth differential versus developed markets has fallen from 6.5% in 2009 to potentially just over 2.0% in 2015.
Several interconnected factors help explain emerging market struggles. These include China’s slowdown, the end of the commodities super cycle and tightening in global financial conditions. The first two have already been playing out on a large scale, having delivered a double blow to the likes of Brazil, Chile, Colombia, South Africa and Indonesia – commodity exporters with close links to China.
The last factor has not yet been a substantial headwind for emerging markets, but is set to become more dominant over the next few months. As the US Federal Reserve embarks on its rate-hiking cycle, the associated rise in funding costs will weigh heavily on emerging markets, particularly in places where external imbalances are relatively stark.
Potential trouble ahead
The recent rally in the dollar – up around 20% in trade-weighted terms since mid-2014 – is a key part of the tighter financial conditions. The associated emerging market currency weakness over the past year – significantly in places such as Russia, Colombia, Brazil, Malaysia, Mexico and Turkey – has been a source of concern among investors.
Currency depreciation is not necessarily a bad thing. It supports exporters and can help reduce imbalances by reducing external deficits. It can shore up activity and boost inflation, at least temporarily – beneficial for the economies facing deflation. Yet currency weakness carries significant risks.
A pronounced fall could lead to an undesirable spike in inflation and inflation expectations, which would force central banks to hike rates and have a detrimental effect on activity, particularly if growth is already low.
Moreover, currency weakness can expose vulnerabilities arising from foreign currency mismatches as the size of unfunded liabilities in foreign currency terms increases, weakening borrowers’ balance sheets. As the dollar is the main foreign currency of emerging market debt issuance, there is a chance that the recent dollar strength could catalyse further trouble for emerging markets, as in the 1980s in Latin America and the 1990s in Asia.
What happens next mainly depends on two factors: first, exposure to dollar-denominated debt; second, prospects for further dollar strength. In terms of the overall debt exposure (including local currency-denominated debt), total external debt in emerging markets has fallen from an average of over 35% of GDP in the 1990s to around 25% in 2013.
Today’s levels of sovereign emerging market hard currency debt in particular are much lower relative to the 1990s crisis periods. As most emerging governments reduced foreign borrowing, abandoned currency pegs and built up foreign exchange reserves, their countries have generally become more resilient to dollar strength. But while governments have been relatively frugal, private sector borrowers in emerging markets have taken advantage of the unusually easy global financial conditions and issued significant amounts of foreign currency-denominated debt since the financial crisis.
Hard currency debt
According to the Bank for International Settlements, emerging market borrowers have issued $2.8tn of international debt securities (as of the first quarter of 2015), of which almost three-quarters was issued by the private sector and a similar share was denominated in dollars.
As emerging currencies have weakened over the past few years, the hard currency debt burden has increased further as a share of GDP, particularly in commodity exporters and/ or countries with large external imbalances, such as Russia, Chile, South Africa, Brazil, Mexico and Turkey. In places where the dollar-debt stock is not matched by dollar assets, and where related servicing payments are not matched by revenues, these vulnerabilities are particularly acute.
In addition, the recent rise in foreign ownership of hard currency debt also can make balance sheets more sensitive to currency fluctuations. As foreign investors might not be willing to continue financing borrowing in light of sustained local currency weakness, countries with high foreign ownership of dollar-denominated debt might be more prone to capital flow reversals. Indonesia, Peru, Mexico, Malaysia and South Africa look vulnerable.
Fed rate hikes
Prospects for the dollar itself are important. The good news is that over the past year, the rally has been relatively well digested. It is certainly no longer a one-directional bet, as market expectations for the start of the rate-hiking cycle have largely been priced in. If the Fed rate-hiking cycle is in line with market expectations ‒ in other words, slower and shallower than before ‒ we might already be close to the peak of the dollar strength in this cycle, and emerging borrowers might escape relatively unscathed.
If, however, the pace of hiking is more aggressive than currently expected, the dollar might stage another rally, exposing emerging market vulnerabilities in light of much tighter financial conditions globally.
Overall, the global backdrop that fuelled the rise of emerging markets in the previous decade is no longer supportive to growth successes. Does it mean the mediocre growth of late is the new normal for emerging market economies? Are we likely to see another wave of emerging market crises as headwinds intensify?
Not necessarily. Emerging governments can still do much to improve the resilience of their economies and raise growth potential through structural reform. Enhancing education, encouraging innovation, improving the business environment and technology are key in this quest. Those emerging markets that succeed in pushing through reform over the next few years are more likely to deliver superior growth outcomes and better returns for investors.
■ Anna Stupnytska is a global economist at Fidelity Worldwide Investments Back