Currency crisis in emerging markets

Friday, October 26, 2018 | By Atul Rai and Manish Wadhwa

Currency crisis in emerging markets

It wasn’t long ago that dynamic emerging markets were considered engines of growth spurring the world economy and had investors lining up for their share of pie. But this has changed, at least for now, since these once booming countries are now facing mounting currency pressures.

Some analysts and investors blame external shocks like rising Fed rates, while others argue that vulnerable exchange rates are due to structural problems in emerging markets. Firstly, global emerging markets have $2.7 trillion in US dollar denominated debt, which they need to pay or refinance by 2025.[i] Emerging markets were able to raise debt for many years since funds were available to them when Fed rates were close to zero. With the Federal Reserve putting an end to quantitative easing (QE), the dollar rose and that debt is now not so cheap. After years of foreign capital inflow, investors have started to pull back funds and with the increasing Fed rates, the US again seems like a more lucrative option.

Secondly, emerging market governments have been engaging in short-term borrowing to sustain large scale construction activities and other public undertakings. Private banks and finance companies were allowed to accumulate foreign debt due to weak regulation policies.  Overdependence on international loans, commodity exports and Foreign Direct Investment (FDI) has left these countries extremely sensitive to global economic conditions. The currency woes of one country can have a cascading effect on other countries. For example, shaky investor sentiment can lead to investors dumping local currencies and siphoning out dollars from emerging markets and placing them in safer havens like the US.

Sometimes governments lack political consensus to take quick and unpopular measures required to stabilize an economy and at other times, central banks fail to tighten their monetary policies. Economic medicines are best taken before the hint of malaise. Though the general trend is indicative of investor’s inclination towards dollars, the payoffs might not be as fruitful as expected. Data from CFTC shows that hedge funds are betting on further dollar gains. The dollar might appreciate further if investors remain risk-averse and continue to seek haven assets in the US, though it may weaken if the economy starts to overheat and chance of a slow-down starts weighing on investors’ mind.

Emerging markets need to build a financial system that is more resilient to external shocks. The governments in emerging markets should  prepare a robust set of fiscal and monetary policy to keep inflation in line. Inflation in single digits and more confident financial markets in local currencies boost investors' morale and provide the scope for long-term financial instruments which will attract foreign capital.

Currency crisis typically follow a series of political, economic and market forces that combine to pressure the exchange rates. Certain factors are beyond control but with appropriate measures the crisis can be kept at a minimum level.

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