This is how emerging currencies will suffer

The Federal Reserve is on track to raise interest rates to contain inflation. The rise in US interest rates is a bad news for emerging market economiesas it increases the debt burden, causes capital outflows and, in general, causes a tightening of financial conditions that can ultimately lead to financial crises.

Fed interest rates are already at 1% and the outlook is continued increases in the remainder of the year. The US central bank is in aggressive mode as its latest hike was half a percentage point for the first time since 2000.

The dollar already has a recurring demand for being a high participation of the US dollar reserves in the hands of central banks (59% the lowest level in the last 25 years) and participate in 80% of global transactions. If we add a higher remuneration for the rise in rates, it is perfectly logical increase in the dollar index that rises 6.35%. The dollar becomes more desired.

To date, emerging countries have enjoyed a tailwind because they have maintained high interest rates in their local economies and have benefited from the bullish cycle of raw materials that has supported the currencies of the countries commodity exporters, including Brazil and South Africa. In the case of the USD/BRA ratio, it has fallen by 13.58% this year, something striking in full rise (appreciation of the Brazilian real).

By the side, commodity importers, such as India, have suffered more inconvenience and the USD/INR ratio is up 4% (rupee devaluation) so far this year. The same happens to China, the USD/CNY pair is up 4.6% (yuan devaluation) since January. The yuan is at its weakest level against the dollar in more than 18 months.

The relationship between US interest rates and emerging countries

The economy works by communicating vessels. The financial contagion effects in emerging economies depend on two assumptions when the Fed starts to increase rates.

The first of them is what is motivating the increase in interest rates. In a normal scenario, rate increases are driven by favorable growth prospects and it has relatively benign effects on emerging financial markets supported by GDP growth.

Now, if the rate hikes are closely related due to concerns about inflation or an aggressive shift in Fed policy, at this point is when emerging markets start to get stressed.

This is the key point now, emerging exporters have benefited from the commodity boom. But if the US wants to attack inflation, emerging commodity exporters will suffer a severe setback.

The second key factor is represented by the internal conditions of the emerging country in question. Financial conditions in economies with increased macroeconomic vulnerabilities they tend to be more sensitive to an increase in rates.

In this case, countries that assume a greater degree of financing in dollars or their growth depends on foreign investment in dollars which manifests itself in a large current account deficit indicates that a high level of recourse has been made to external financing. When interest rates rise in the United States, there is a repatriation of money. This happened in 2022 in Turkey and Argentina with their respective currency crises.

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