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Currency Crises in Emerging Markets?

19 March 2015  |  1945 views  |  0

‘It’s like a unilateral U.S. military operation, but global infrastructures are left standing’

The sheer size of the U.S. economy and the fact that the greenback is the world's reserve currency weigh heavily on what happens in the global markets. Any fiscal or monetary policy moves announced by the Federal Reserve Bank are especially important to international investors, because currency exchange rates have immediate effects on the purchasing power of individual currencies, trade balances and global economic activity. The fundamentals of the U.S. economy are sound, and the country's rapid growth is in stark contrast to the economies of Russia, Europe and emerging market nations. Therein lies the dilemma: Global prosperity is heavily reliant on what happens in the U.S., but a stronger dollar is not necessarily a good thing for the global economy.

How a Strong US Dollar Impacts on Weaker Currencies

Speculation drives sentiment and currencies. The USD has been buoyed by expectations of an interest rate rise by the summer of 2015. What this means in simple terms is that U.S. financial institutions and investments in the domestic economy will see a massive influx of foreign capital. However, in order to attract that capital, foreign currencies need to be sold and U.S. dollars need to be purchased. By selling foreign currencies, those currencies weaken and the demand for U.S. dollars increases. Increased demand leads to an appreciation of a currency relative to other currencies. Across the board, emerging market nations such as Russia, Turkey, Brazil, South Africa and scores of others have seen a deluge of sales of local stocks and shares in favor of U.S. denominated stocks, shares and currency.

The South African rand as a case in point is now trading at a 13-year low figure, and approaching an exchange rate of 13:1 to the USD. This same picture is evident with other emerging market currencies like the Brazilian real (down almost 20% against the USD this year), the Turkish lira, and the Russian ruble. Exceptionally high volatility now characterizes the currency markets, which is evident in binary options trading where call options on the greenback and put options on emerging market currencies are the norm. As the quantitative easing programme in the U.S. tapered off, Fed policy now wants to keep the economy on track for a full recovery. Interest-rate hikes make the costs of borrowing money more expensive. The Fed enacts this to achieve full employment, GDP growth and stable prices. Too much money flooding the economy leads to rapidly rising prices which can have an inflationary effect on the economy. The Fed has opted to stabilize the U.S. economy now that quantitative easing (QE) has worked.

The Russian Bear

Across the pond in Russia, the Russian Central Bank recently slashed its lending rate. This was done to stimulate the economy and get people to spend more. The Russian economy has been hard-hit by sanctions, massive divestiture and associated capital flight. The repo rate has been reduced to 14%, as part of a quantitative easing process which was initiated in January 2015. Russia is suffering as a result of historically low oil and gas prices – the chief sources of income for the Russian economy. In 2015 to date, the Russian ruble has managed to claw its way back to stable territory, but it remains precariously balanced.

Data that has been released by the Russian authorities confirms that there are declines in GDP, consumer spending, consumer investment and real wages. As a result of this, it is clear that the Russian economy is in the throes of a bear market. It is expected that the interest-rate cuts will act to mitigate these sharp declines in Russian productivity and economic performance. Typically, inflation needs to be declining before interest-rate cuts are adopted, but multiple factors come into play vis-a-vis interest rates. During 2014, the Russians raised interest rates in an effort to lure foreign capital back to Russia. The Russian Central Bank expects up to 4% GDP declines during 2015, up 1% from the beginning of the year.

How Are Emerging Market Economies Defending Their Currencies?

Any short-term measures of selling dollars by the central banks of emerging market economies are likely to fail in the long term, given the fundamentals of international investment. The fact of the matter is that the U.S. economy presents investors with a much safer and more trusted investment than the highly volatile emerging market nations. When interest rates are high in the U.S. no amount of central bank sales of USD will have a lasting effect on investor sentiment. Mexico recently announced that it would be selling USD to prop up the Mexican peso. The last time it did this was at the height of the financial crisis in 2008. These measures provide short-term relief to local currencies, but the long-term prognosis is that these measures are not sustainable.

Past Policies and Future Performance In much the same fashion, the Turkish Central Bank released foreign currency back into the banking system. This also provided short-term relief to the Turkish lira, but the currency is still down over 10% against the USD in 2015. By depleting their foreign currency reserves in the short term, foreign countries can support their currencies in the short term. However, the fundamentals of the red-hot American economy will power well beyond the myopic policies of dollar sales by central banks elsewhere. There are however several policies that emerging market nations can theoretically adopt to attract foreign capital – such as raising interest rates – but these measures will hurt more than heal their ailing economies. Since economic activity is already limited, making capital more expensive limits credit, investment opportunities and economic growth. Overall, the currency arena provides for a highly complex network of interactive bulls and bears with incredible profit potential for savv

 

U.S. Economy TagsTrade executionTransaction banking

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