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Dollar strength: Why developing countries are nervous

, June 20, 2024, 0 Comments

us-dollar-marketexpress-inEmerging economies are wary of the strength of the US dollar. They are taking steps to ensure the soaring greenback doesn’t fuel inflation and derail growth. We explain why they remain vulnerable.

In addition, growing tensions in the Middle East following Iran’s attacks on Israel have boosted the US currency more recently thanks to its safe-haven status.

Finally, while many economies worldwide are experiencing moderate growth, US economic indicators, ranging from employment figures to retail sales, are consistently outpacing expectations.

While several emerging economies still offer higher yields on their bonds than US debt, the gap has been shrinking. At the start of last year, Brazil’s policy rate was 13.75%, Chile’s was 11.25% and Hungary’s was 13%. Since then, central banks in the three economies have trimmed their key rates, narrowing the yield advantage for potential investors.

Emerging economies particularly exposed

Developing countries are particularly sensitive to the negative effect of the dollar’s rise, as a surge in the value of the greenback drives up interest on their dollar-denominated debt, increasing their interest burden.

According to the International Monetary Fund (IMF), a 10% rise in the dollar on the currency market would push down real gross domestic product (GDP) in emerging economies by 1.9% after one year, with adverse economic effects lasting more than two years.

In 2022, when a similar dollar strengthening was underway, Sri Lanka fell effectively into default as its currency depreciated. Other emerging economies tried to prevent their currencies from depreciating by raising interest rates ahead of the US Fed in 2021 and 2022.

At the beginning of 2024, many believed that US interest rates would be lowered by the end of the year and that the dollar’s strength would be corrected. But now the dollar may be on track for a longer-than-expected rally.

Emerging markets already in crisis mode

Several emerging-market countries have already begun to take action. Brazil’s central bank, on April 1, intervened in the foreign exchange market for the first time since President Luiz Inacio Lula da Silva took office at the beginning of last year. Although the government and the central bank have not clearly explained their intentions, some in the market believe that the purpose was to check the depreciation of the real.

Bank Indonesia (BI) has been stepping in to shore up the rupiah, which is at a four-year low, hovering around the level of 16,000 rupiah to the dollar. BI Governor Perry Warjiyo told reporters after attending a meeting with President Joko Widodo on Tuesday, that the central bank is “always in the market and will ensure the currency is stable.”

Turkey’s central bank also raised its policy rate by 5% to 50% in March in response to the lira’s depreciation and accelerating inflation.

However, developing countries also fear a situation where their economies cool down due to interest-rate hikes to curb inflation, as in Turkey. Just as they were ready to begin cutting rates, the delay to US rate cuts makes it more likely that emerging economies will be forced back to raising rates.

Kota Hirayama of SMBC Nikko Securities says “the risk of a return to inflation is increasing in emerging economies” because of exchange rates and rising oil prices.

“However, they are unlikely to raise interest rates. Rather than responding with monetary policy, they are likely to temporarily respond to the depreciation of their currencies through interventions to buy time,” he said in a note to investors.

China, for example, is using its daily currency fixing to support the yuan, and some Chinese state-owned banks are selling dollar reserves. Bank Indonesia is more or less doing the same as it uses its foreign exchange reserves to buy rupiah. Malaysia’s central bank wants companies associated with the state to repatriate foreign investment income and convert it into ringgit.

G20 to address dollar strength

These concerns are not just limited to developing economies, Japan and other developed countries are nervous about the continued depreciation of their currencies.

Speaking about this week’s G20 meeting of finance ministers and central bank governors in Washington DC, Japanese Finance Minister Shunichi Suzuki said Friday (April 12) that “it is possible that [the dollar] will be on the agenda. We have discussed capital flight before.”