How Emerging Market Currencies are Weathering US dollar Surge

Central banks around the world appear relentless in their fight to keep stubbornly high inflation from becoming embedded in their economies. This is most evident in the US, where an above-expectation June inflation report saw the market increase the probability of the Federal Reserve hiking rates by 100 basis points at its July meeting.

This expectation has since receded, but the Fed’s actions are helping to raise the value of the US dollar, which creates headwinds elsewhere, mainly in emerging economies.

The US dollar has risen 12 per cent since the start of the year against a basket of developed-market currencies, of which the biggest weights are the euro and the yen. There are specific forces keeping the greenback elevated against the world’s other major players.

The euro recently hit parity with the US dollar. That’s great if you’re planning a summer holiday in Greece, less so if you live there. The weakness in the euro reflects the risk of a recession in the single currency bloc as a result of the energy crisis and natural gas supplies from Russia – which has seen prices more than double in recent weeks – but also the political risks stemming from Italy’s government crisis.

Meanwhile, the Bank of Japan’s still very loose policy settings and commitment to keep buying bonds and limit the rise in the 10-year government bond yield are at odds with nearly every other central bank around the world. This large difference in policy settings is holding the yen back.

These two factors alone should see the continued strength of the US dollar. This raises very real challenges for emerging economies, where a stronger greenback has historically been a challenge for both economic and market performance.

However, surprisingly, many emerging economy currencies have not performed as poorly as expected in an environment where the US dollar is trading close to its highest value in nearly 20 years. Coming into this period of exceptional dollar strength, emerging currencies already appeared very cheap, and so the downside may be limited. As they say, it’s hard to hurt yourself falling from a basement window.

Moreover, many emerging market economies are in better shape entering the period of tighter US monetary policy and slowing economic growth than in the past. Comparisons are often made to 2013 when the Fed hinted at ending quantitative easing, which led to a sharp sell-off in emerging market assets. It’s fair to say that a lot has changed since then.

Emerging market central banks were quick to confront the rise in inflation and the pickup in demand as the effects of the pandemic waned, compared to central banks in developed markets that are behind the curve and have accelerated their policy tightening to catch up with the inflation outlook – not to mention restoring their inflation targeting credibility.

This is not to say that central bankers in either developed or emerging market economies have finished raising rates, but there is less urgency in developing nations.

Then there is the current account position. If too much money is going out, and a nation is in deficit, it must borrow to plug the gap. A large deficit is viewed as a weakness, given the heavy reliance on borrowing to fund the shortfall.

This heightens the risk of heavy selling of the currency should the economic outlook take a turn for the worse. This is what happened in 2013 for countries with large current account deficits, including Brazil, India, Indonesia and South Africa.

Today, their economies are in a much healthier position with much smaller current account deficits or, in the case of Indonesia, a small surplus.

These factors may be of little comfort as the we contemplate the potential impact on emerging markets of a looming recession in the US and Europe. But these buffers could make the difference between a mid-cycle slowdown and a recession for many emerging economies, including those in Asia. Still, the performance of many emerging market currencies remains hostage to the prospects of the US dollar.

The sight of some green shoots of economic recovery in China may well prove to be the catalyst for renewed foreign investor enthusiasm for Chinese assets. But increased demand for yuan-denominated assets may not necessarily run alongside material rises in the value of the yuan on foreign exchanges.

All foreign exchange trades are comparative judgments. Market participants weigh up the prospects of one currency against another. In the current context, as the second half of the calendar year begins, the US dollar remains strong on foreign exchanges. Other currencies, including the yuan, have been playing supporting roles.

That said, recent Chinese data suggests China’s economy is starting to pick up.

Green shoots of economic recovery may be discerned in figures released last Thursday showing that China’s official manufacturing purchasing managers’ index (PMI) rose to 50.2 in June, up from May’s 49.6, the first time it had been above 50 and in expansion territory since February.

In addition, the official Chinese non-manufacturing PMI, which reflects business sentiment in the services and construction sectors, hit 54.7 in June, in sharp contrast to May’s 47.8. Again, this was the first time this figure had been above 50 since February and it was also the fastest pace of expansion in this sector in 13 months.

Also, while acknowledging that problems do remain, the American Chamber of Commerce in China said last week that US firms operating in the country were reporting marginal improvements in business conditions.

Admittedly, green shoots don’t always take firm root but they can be nurtured, and Beijing has the policy tools at its disposal to encourage their growth.

As Premier Li Keqiang noted recently, China has “been implementing prudent monetary policy and not printing excessive money in recent years”. Given that inflation in China is not a problem for the People’s Bank of China now, the central bank has room to provide targeted monetary policy support to the economy if required.

Those who buy into this narrative might well be tempted to purchase Chinese assets but for foreign investors, who necessarily take on an exchange rate exposure when moving from their home currency into the yuan, there is also a judgment to be made on the renminbi’s likely trajectory on the foreign exchanges.

As it is, outside China, many other major central banks, led by the US Federal Reserve, are battling inflation. The Fed is now making financial conditions more restrictive by both hiking US interest rates at pace and embarking on quantitative tightening.

Given the centrality of the US dollar to the global economy, tighter US financial conditions will initially and generally translate into greenback strength, and the current situation is no exception.

As US dollar strength also tends to be disinflationary, and the primary objective of the Biden administration, as well as the Fed, is to curb US inflation, greenback resilience is probably not unwelcome in Washington at the moment.

Of course, if the foreign exchanges conclude that the Fed’s new-found zeal for tighter monetary policy risks pushing the United States economy into actual recession, then the dollar’s allure may fade.

But while broad market enthusiasm for the greenback persists, US dollar-based investors looking to purchase yuan-denominated Chinese assets might conclude that unless they hedge some or all of their exchange rate risk, any future capital gains on those Chinese investments could be eroded if, in the meantime, the yuan loses ground against the dollar.

Elsewhere, with the European Central Bank way behind the Fed in tightening monetary policy and the Bank of Japan steadfastly still wedded to its own ultra-accommodative stance, euro-based and yen-based investors, who may be looking at Chinese asset purchases too, also have currency risk calculations to make.

If their calculation is that the US dollar will continue to perform well versus the euro and the yen, while the yuan remains relatively stable on the foreign exchanges, then those investors might well conclude that they should proceed with their investments in Chinese assets on an unhedged basis. This would enable them to benefit from any future appreciation of the renminbi against their home currencies.

Addressing exchange rate risks in cross-border investments is nothing new but what makes the current situation more interesting is the need to separate any optimistic view on Chinese economic prospects from an expectation of corresponding yuan strength on the currency markets.

In the current circumstances, it is their view on the greenback, not China’s green economic shoots, which should guide overseas investors as they purchase Chinese assets and manage the attendant exchange rate risk.