The View | Wilting US dollar may derail the boom in emerging markets

Emerging market investors have a spring in their steps.

Since the start of this year, the equity markets of developing economies have shot up nearly 10 per cent, according to the MSCI Emerging Markets Index, a leading gauge of stocks in emerging economies. This brings the index’s gains since its post-financial crisis low in January 2016 to a whopping 72 per cent.

What is more, emerging market bonds have withstood the recent sell-off in global debt markets, convincing investors to keep pouring money into the asset class. According to JPMorgan, emerging market bond funds have attracted US$9.3 billion in inflows since the beginning of this year, having already enjoyed record inflows of US$113 billion in 2017.

The rally in emerging markets is being turbocharged by the plunge in the US dollar which is having its worst start to the year since 1987, exacerbated by contradictory messages from US President Donald Trump’s administration at last week’s World Economic Forum in Davos that reinforce the perception among traders that the White House favours a weak greenback.

The sharp fall in the dollar has been the key factor behind the nearly 15 per cent rise in the MSCI Emerging Markets Currency Index, a leading measure of the performance of developing market currencies, since January 2016. Last Thursday, the index reached its highest level on record.

Yet while the dollar’s steep decline over the past year has proved a boon for emerging market assets, it risks becoming too much of a good thing.

Although the greenback’s plunge makes it easier for emerging markets to service their dollar-denominated debts and contributes to an easing in financial conditions, increasing investors’ appetite for so-called risk assets (especially ones purchased through the use of the dollar as a cheap funding currency in a strategy known as the “carry trade”), the dollar’s hefty decline could end up backfiring on emerging markets.