Vulnerable emerging markets haunted by dollar peg
Amid the carnage in the financial markets of developing economies, a common refrain among investment strategists is that the current sell-off is much less severe than the full-blown emerging market (EM) crises in the 1990s.
Much is made of the fact that many of the vulnerabilities and weaknesses that led to earlier crises no longer exist. Balance of payments positions are considerably stronger - many emerging Asian economies were running dangerously large current account deficits in the late 1990s which have since been turned into sizeable surpluses - while the bulk of EM government debt is now denominated in local currencies.
The phenomenon known as “original sin” - the inability of EMs to borrow abroad in their local currencies - is now much less prevalent in the developing world.
The reduced reliance on dollar funding allowed many EMs to jettison their fixed, or pegged, exchange rate regimes (which contributed to earlier crises by depriving many countries of much-needed flexibility in monetary policy) in favour of free floating ones, reducing pressure on foreign reserves and boosting export competitiveness.
Yet not all EMs discarded their dollar pegs.
Some economies, particularly those based on commodities, retained them, mainly in order to import the credibility attached to US monetary policy and avoid the adverse effects of sharp swings in currencies.
The “peggers” are now once again under pressure.
China’s surprise decision on August 11 to undertake the biggest devaluation of the yuan in two decades, thereby breaking the currency’s informal peg to the dollar, has placed additional strain on EM currencies.
The combination of a resurgent dollar, a collapse in oil prices and a sharp increase in speculative positions against EM currencies perceived as vulnerable is a triple whammy for those EMs seeking to defend their pegs.
Investors are once again buying insurance against a possible loosening or abandonment of Hong Kong’s 32-year-old dollar peg, with the cost of options surging to their highest level in over a decade.
On August 20, the central bank of oil-rich Kazakhstan - which according to JP Morgan spent US$18 billion over the past year defending the country’s dollar peg - allowed the nation’s currency, the tenge, to float freely, triggering a 22 per cent fall in the tenge to a record low versus the dollar.
In an interview with Bloomberg, Kazakhstan’s premier, Karim Massimov, said the decision to devalue the tenge was a foretaste of things to come. “At the end of the day, most of the oil-producing countries will [adopt a] free-floating [currency] regime. I do not think that for the next three to five, maybe seven years, the price [of] commodities will come back to the level that it used to be at in 2014.”
He may just be right.
Other dollar pegs in oil-producing countries are under strain. Saudi Arabia’s 29-year-old fixed exchange rate is seen as vulnerable, partly because the riyal, the country’s currency, is one of the most liquid foreign exchange markets in the Middle East, but also because of Saudi Arabia’s relatively large population.
“The need to maintain large pubic spending has been seen as a drag on [foreign] reserves,” JP Morgan notes.
Yet at least Saudi Arabia boasts the world’s third-largest foreign reserves, giving it the firepower to defend its peg.
This is in stark contrast to Nigeria, another prominent “pegger” and large oil exporter, whose foreign reserves have fallen 23 per cent over the past year to US$30 billion, covering just five months’ of imports. Instead of devaluing the naira, Nigeria’s currency, the central bank has resorted to controversial foreign exchange controls and protectionist economic policies in the hope of shoring up the currency, which has already lost 20 per cent against the dollar over the past year.
Still, many vulnerable EMs with free floating exchange rate regimes are under as much, if not greater, pressure. The Russian rouble, the Brazilian real and the Turkish lira have lost 90 per cent, 58 per cent and 37 per cent against the dollar over the past year.
The current EM sell-off has been fairly indiscriminate, with both “peggers” and “floaters” and net exporters and importers of oil suffering sharp declines in asset prices.
The choice of exchange rate regime, it seems, has little bearing on sentiment.
Nicholas Spiro is managing director of Spiro Sovereign Strategy