By Jamie McGeever
ORLANDO, Florida (Reuters) – A strong U.S. dollar and high Treasury yields pose significant challenges to emerging economies, and policymakers have no easy way to counter this powerful one-two punch.
As American exceptionalism casts a shadow over the rest of the world, many emerging markets are facing weaker currencies, higher costs of servicing dollar-denominated debt, reduced capital flows or even capital flight, subdued local asset prices and slowing growth.
Added to this is the uncertainty and nervousness surrounding the new US administration’s proposed tariff and trade policies.
History has shown that when trends like these manifest in emerging markets, they can create vicious cycles that quickly accelerate and prove difficult to break.
Unfortunately, there doesn’t seem to be a simple roadmap 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 promises to ease monetary and fiscal policies to revive the economy; Brasilia promises substantially higher interest rates and tries to get its budget in order.
Their divergent trajectories – and ongoing struggles – suggest that no matter where emerging economies are in terms of growth, inflation and fiscal health, they are likely to face a difficult road ahead in the coming years.
GO WITH THE FLOW
Brazil and China are clearly in very different places, not least on inflation. Brazil has a lot of it, prompting aggressive actions and central bank guidance. China, on the other hand, is struggling with deflation and is finally starting to cut interest rates.
Another difference is the fiscal space each country has to generate growth. Brazil’s unwillingness to cut spending sufficiently is a major cause of the real’s slump and the central bank’s eye-popping tightening. The market forces Brasilia’s hand.
The market is also putting pressure on Beijing, but pushing the country in the opposite direction. The combined size of the support packages and measures announced since September to revive economic activity are in the trillions of dollars.
But even though the two countries’ tactics are diametrically opposed, the outcomes so far are similar: slow growth and weak currencies, a picture that most emerging countries will recognize. The Brazilian real has never been weaker and the tightly managed yuan is close to the lows last reached 17 years ago.
As Reuters exclusively reported, China is considering whether to allow the yuan to weaken in response to threatened US tariffs, with Capital Economics analysts warning the yuan could fall to 8.00 per dollar.
But allowing the yuan to depreciate is not without risk. This could accelerate capital outflows and lead to currency devaluations in Asia and beyond.
A race to the bottom for emerging market currencies would be highly problematic for the countries involved as the dollar is now a bigger driver of emerging market flows than interest rate differentials, the Bank for International Settlements said. Analysts at State Street (NYSE:) estimates that exchange rates explain about 80% of local emerging market government bond returns.
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 decline of 24%.
“Our forecast is based on a base case, but significant downside risks remain,” the IIF said.
FINANCIAL CONDITIONS ARE CONSIDERED
Emerging countries also face headwinds from higher US government bond yields.
Although the pile of government and corporate debt in hard currency is small compared to that in local currency, it is growing. Total (EPA:) Emerging market debt is now approaching $30 trillion, or about 28% of the global bond market. In 2000 that was still 2%.
And the pressure of higher financing costs is being felt in real time. According to Goldman Sachs, financial conditions in emerging markets are the tightest in almost five months, with the spike in recent months almost entirely due to the rise in interest rates.
Real interest rates are now much higher than during Trump’s first presidency. But many countries may still struggle to cut them as this could “create financial stability concerns by putting pressure on exchange rates,” JP Morgan analysts warn.
On the positive side, emerging countries have significant currency reserves to fall back on, especially China. Most of the world’s $12.3 trillion in foreign currency reserves are held by emerging countries, while $3.3 trillion alone is in Chinese hands.
Emerging market policymakers are caught between a rock and a hard currency and may soon have to dip into this stock.
(The views expressed here are those of the author, a columnist for Reuters.)
