It’s the interest rate, dummy!

Since the US elections the dollar bull carried on its way towards its historical highs. Seeing this several columnists and analysts expressed their concern regarding the effect of strong US dollar on the emerging markets. At first glance it could be confusing why people are fearing a strong greenback. For years everyone wanted weaker domestic currency (stronger foreign ones) to boost export margins or domestic inflation, what could have changed?

First of all, as weaker domestic currency indeed boosts margins (expressed in local currency terms) one should not forget, that not all companies are exporters. During the recent years more and more emerging economies grew to a size, where simply relying on external demand to generate growth is not sufficient. With a struggling internal supply chain and eroding purchasing power it would be hard for policymakers to recourse their economy onto a more domestic reliant way. This is especially true, if the given economy is less diversified, and pricey exports would crowd domestic goods out.

Secondly, it’s not just about running costs. As it has been nearly a decade of cheap money lots of emerging economies relied on foreign funding. If foreign investors start to pull out of the economy, being afraid, that their investment would lose money as emerging currencies depreciate it would be even harder to pay the principle back, resulting in a self-fulfilling expectation and fire sales.

Thirdly, its more about the interest rates, than the currency itself. The most powerful tool, which sets the course for currency trend is the interest rate differential (in my experience you ought to look at the two-year differentials for a more precise correlation). In their current state, most emerging economies are between a rock and a hard place.

Due to the maturity of the US cycle and future policy expectations US rates started to rise. If emerging central banks hike rates to protect their currency they have to increase debt servicing costs for the already indebted private sectors. If they let their currency depreciate they have to risk the fire sales.

If this wouldn’t be bad enough, there is an additional factor to the equation: the emerging countries running a biggest ever interest-rate swap with the us, and they are on the wrong side. On the one hand, many of them have reverse assets in US dollars, however, these are mostly in fixed yielding government bonds. On the other hand, as emerging banks acquired funding through the interbank market they offered loans with floating rates in order to hedge against fluctuating rates. Many private companies feel the pain of rising rates right away, while others only take the bitter pill at refinancing.

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