Still reeling from the effects of a global pandemic that lingered on for two years, emerging countries are now threatened with capital flight, inflation, and potentially debt defaults as the dollar’s rise to a two-decade high is further tightening the screws on the economies of the emerging markets. Previous emerging market crises have almost always been related to rising dollar values. Developing nations must tighten their monetary policies when the dollar increases to prevent declines in their own currencies. Failure to do so would increase inflation and the expense of repaying debt in dollars.
Growing Crisis Risk – Emerging Markets Burn Through Currency Reserves
The potential risk of a wave of defaults affecting the world’s most fragile economies is growing as emerging markets are burning through their reserves of US dollars and other foreign currencies at the fastest rate since 2008. According to data from the International Monetary Fund, the foreign reserves of emerging and developing nations have decreased by $379 billion this year through June.
According to a report by JPMorgan Chase & Co., excluding the effects of exchange-rate fluctuations and the sizeable foreign exchange reserves of China and Gulf oil exporters, emerging economies are witnessing the steepest drops since 2008. Central banks all across the globe are using reserves to protect their currencies against the strengthening US dollar and to cover growing import costs for food and fuel.
Economists have been warning that countries including Ghana, Pakistan, Egypt, and Turkey are all at risk of experiencing a currency crisis. Sri Lanka has been unable to import needs like fuel and other items since its offshore bond defaulted in May. According to the International Air Transport Association, the central bank of Nigeria is reportedly prohibiting foreign airlines from returning $464 million in an effort to conserve US dollars, which highlights the fact that Nigeria is also experiencing a severe foreign currency crisis.
Senior fellow at the Council on Foreign Relations and a former adviser to the United States, Brad Setser, has stated that “there is an immediate risk in a few fairly significant countries.” These are countries that did not have sufficient reserves, to begin with. Now, since they can no longer acquire financing, they are spending their reserves to pay for imported food and energy, and if the situation lasts much longer, they definitely run the risk of a currency or debt crisis.
While these nations are on the edge of running out of foreign currency reserves, larger emerging markets like China, India, and Brazil seem to have enough to weather the storm. Despite this year’s historic sell-off in emerging-market assets, investors have emphasized that they believe there is minimal chance of a generalized crisis and that the stress is limited to a small number of countries that have been racked by persistent political and economic issues. However, the pressure seems to be going beyond those well-known weak spots. These include the Czech Republic, which has lost 15% of its reserves this year, and Hungary, which has seen a 19% decline in reserves, according to the data source CEIC. The Russian invasion of Ukraine and Moscow’s tightening of gas supply to Europe have had a severe impact on both countries. The value of the Hungarian currency against the dollar has decreased by over 30% this year.
Why Dollar is Appreciating
The US dollar has gained over 11% since the beginning of the year and has now, for the first time in two decades, equaled the value of the Euro. A large number of major currencies have depreciated against the dollar, with big implications for the developing world.
The primary reason why the dollar is gaining is that there is a high demand for dollars. The economic outlook of most economies indicates a major slowdown. Meanwhile, the conflict in Ukraine has greatly increased geopolitical risks and market volatility. Additionally, the US Federal Reserve has rapidly raised rates as a result of historically high inflation.
These, among other factors, are causing a flight to safety, where investors are exiting their positions in Europe, emerging markets, and other places in search of safety in US-denominated assets, which must be purchased with dollars.
The market is still anticipating swift Fed rate increases. Emerging markets have previously faced crises due to comparable instances of rapid rate increases in the past as well. This was the situation during the “Lost Decade” in the 1980s in Latin America and the Tequila Crisis in Mexico in the 1990s (which then moved towards Russia and East Asia).
Potential Impact on Emerging Markets
Many developing nations, particularly the poorest, are unable to borrow in their own currencies at the levels or for the duration that they desire. Lenders do not want to take the chance of receiving repayment in the unstable currencies of these debtors. Instead, these countries typically borrow in dollars and promise to repay this debt in dollars, regardless of the exchange rate. When the dollar gains strength in relation to other currencies, these repayments become significantly more expensive in terms of native currency. The percentage of debt denominated in dollars is relatively low among East Asian countries and Brazil, which has benefited due to a number of reasons, including the large dollar holdings of the central bank, the fact that the private sector appears to have done well to protect itself from currency volatility, and the fact that it is a net exporter of commodities.
As the US Federal Reserve jacks up interest rates, other central banks must increase their own rates to remain competitive and protect their currencies. In other words, investors must be persuaded to invest in an emerging market rather than moving their money into safer US assets by promising them larger returns.
However, this raises a problem. On the one hand, it is clear that a central bank aims to safeguard foreign investment in the domestic economy. But on the other hand, an increase in rates also increases the cost of domestic borrowing and has a dampening impact on growth as well.
The Financial Times, citing data from the Institute of International Finance, recently reported that “foreign investors have pulled funds out of emerging markets for five straight months in the longest streak of withdrawals on record.” This is critical investment capital that is escaping from the emerging markets towards safety. Finally, a domestic downturn will eventually affect government revenue, which might compound the debt issues already discussed.
In the short term, a strong dollar can also impact trade. The US dollar dominates international transactions, and firms operating in non-dollar economies use it to quote and settle trades, including for key commodities like oil, which are bought and sold in dollars.
Furthermore, many developing countries are price-takers (which means their policies and actions don’t impact global markets) and are primarily dependent on global trade. Thus, a strong dollar can have severe impacts on them domestically, including spiking inflation.
As the dollar strengthens, imports become expensive (in terms of the domestic currency), thus forcing firms to decrease their investments or spend more on crucial imports.
Even though the long-term trade picture might look beneficial for some, overall, it is an uneven picture. Although imports are more expensive amid a strong dollar, exports are relatively cheaper for foreign buyers. Export-led countries may be able to benefit as increased exports boost GDP growth and foreign reserves, which helps to alleviate many of the issues.
Outlook on Emerging Markets – Key Insights
A report by Lazard Asset Management detailed an outlook of the emerging markets for the year 2022. The insights include:
Emerging Markets (EM) equities (MSCI EM Index) outperformed developed markets (MSCI World Index) in the second quarter, finishing down approximately 11% compared to down 16%, respectively. This indicates an almost 18% decline for the first half of 2022 for EM versus an almost 21% decline for developed countries. In terms of the sector perspective, information technology, financials, and materials led the EM Index lower, while Taiwan, Korea, India, and Brazil did so from a country perspective. The conflict between Russia and Ukraine, a stronger US dollar, tighter monetary conditions in the United States (meaning the start of quantitative tightening and the most aggressive rate hike since 1994), as well as the balance between China’s zero-COVID policy and supporting economic growth weighed heavily on emerging markets equities.
Emerging Markets Growth amid Inflation
Soaring inflation, aggressive monetary tightening, and the looming possibility of a recession are not just regional but also global fears. Around the world, central banks appeared determined to prevent high inflation from becoming entrenched.
However, pandemic-related inflationary pressures will be more difficult to control than cyclical pressures. In addition to this, food and energy price rises have been hiked by the war in Ukraine, and these prices contribute to a large portion of the inflation basket for many emerging markets countries in particular. Higher costs for these goods will likely weigh heavily on people in these areas and may leave a marked social impact.
Currencies that are supported by economies with high-value commodity exports, such as copper and oil, can lower the impact of higher import prices for food and energy. For example, while inflation across emerging markets generally remains high, energy exporters such as Brazil and Saudi Arabia are benefiting from improved current accounts, as compared to energy importers such as India and wheat importers such as Egypt and Indonesia. At the same time, countries such as Hungary, Serbia, Turkey, Argentina, and India are all trying to limit exports of certain agricultural products in response to the crisis of rising inflation, which further causes price increases and elevates fears of food shortages. Also, some emerging markets countries like Turkey and Argentina, are still hindered by legacy structural issues, which may have become even worse, particularly for countries with relatively high US dollar-denominated debt.
Block Inflation or Promote Growth?
For many emerging markets countries, navigating a post-pandemic recovery means taking a deliberate course of action when it comes to the economy: keep inflation in check at the risk of slowing growth. The trade-off and the message are clear.
Most of the central banks have been aggressive pandemic recovery rate hikers like Brazil (with June’s increase marking the eleventh straight increase in a row), while others like Mexico preemptively increased rates relative to the US Fed and have since been moving more or less in accordance with the Fed. Whatever the course may be, due to the rate-tightening efforts, growth is expected to fall for these countries while inflation, in general, is expected to peak in the second half of 2022, with near-term risks to both food and commodity prices still to the upside.
Ultimately, the balance among countries for easing inflation and improving growth is what will be critical to steady global growth. As situations improve across regions, it will be dependent on the timing and then tapping into the attractive investment opportunities that arise from uncertainty.
Earnings outlooks might be too high as emerging markets countries suffer the ripple effects of COVID-19 lockdowns, inflation, and the Ukraine war. The expectations for 2022 earnings growth in emerging markets equities remain in negative territory (-3%) overall, weighed down by slowing growth, weakening currencies, and supply chain disruptions.
However, emerging markets are a diverse asset class, and experiences are likely to differ. Earnings growth expectations in Latin America lead the developing world (15%), outpacing Japan (-8%) and Europe (12%) but lagging behind the United States (19%) as the commodity boom props up sentiment. Latin America’s improvement has spread across sectors largely driven by upward revisions within the energy, materials, financial, and communications services sectors.
Outside of Latin America, the earnings outlooks of emerging markets may, at first, blush, appear more gray than bright, but finding good opportunities at the right price is possible.
China Looks Set for Growth, Despite Challenges
China’s growth trajectory will likely show a recovery in the second half of 2022 despite any remaining zero-COVID policy headwinds, which have contributed to a sharp decrease in key economic indicators during the second quarter. In April, factory activity dropped to the lowest level in more than two years, with the official manufacturing PMI dropping to 47.4 from 49.5 in March. A reading of 50.2 in June, however, marked the first month of growth since February (above 50 signifies an expansion). These numbers may still fail to capture the full extent of the economic damage from COVID-19 lockdowns in Shanghai and elsewhere that were imposed in the middle of March.
The scale of recent losses, however, has caused Chinese authorities to assure markets that they stand ready to act, signaling a willingness to boost infrastructure spending to reach the GDP target of about 5.5% and resolve regulatory issues in the technology sector. However, these promises may not be sufficient to alleviate investor fears in the near term. Since its peak in February 2021, the MSCI China Index lost more than half of its value. (China also moved from 47% of the MSCI EM Index to 30%.) On the other hand, however, the China index has recovered nearly 30% from the lows of mid-March.
China remains a major market with extensive growth potential and an environment of innovative thinkers and producers. For the country, recovery will mean the normalization of production lines, which were interrupted by the pandemic and lockdown restrictions; the impact of recent policy support measures gradually nourishing the economy, especially for infrastructure investment; and a bottoming, or even a modest recovery, in the housing market.
As we step into the latter half of 2022, the key question is whether the global economy can weather the higher inflation expectations and tighter monetary conditions, or if the world is slipping into recession, particularly in the United States, and what that would mean for the developing world. As compared to the developed world, emerging markets equities have held up better this year, and this could be an attractive entry point for investors to (re)gain exposure to the asset class. Emerging markets, which offer access to higher economic growth, are trading at a 30% valuation (price to earnings) discount to developed markets while offering investors a higher dividend yield, a higher free cash flow yield, and a return on equity profile that has been improving since the end of 2020.
However, the fact remains that a dollar strength and domestic currency weakness translate into higher import bills, therefore accelerating inflation. While emerging markets started their tightening cycles well before developed peers, inflation has consistently exceeded expectations.
The rates are exceptionally high, as annual inflation in Argentina runs above 50% and in Turkey at 70%. Even wealthier emerging economies such as Hungary are seeing double-digit inflation. The International Monetary Fund expects inflation to average 8.7% in emerging markets this year – some 2.8 percentage points higher than projected in January.
Turkey, Tunisia, Egypt, Ghana, and Kenya, are all among the countries seen at risk due to their hard-currency debt burdens, current account deficits, and heavy reliance on food and energy imports.
With all this going on, a strengthening dollar was the last thing developing countries needed. Looking at the past challenges, in the early 1980s, the last time the US had a truly stubborn inflation problem to deal with, the dollar went up by close to 80 percent. History may not quite repeat itself, but if the dollar is going to keep strengthening with a ferocity comparable to that of 40 years ago, the ride will be bumpy for emerging economies.