Emerging market currencies feel the heat as US economy brightens

A stream of broadly upbeat US economic data is opening up fissures in the foreign exchange markets. Market participants are recognising that the balance of risk is changing. Emerging markets, which have enjoyed substantive capital inflows, will not be immune to this process, and certain currencies are already feeling the heat. 

Emerging markets were major beneficiaries of inward capital flows last year, as evidenced in data from the Bank for International Settlements on 30 April. Overall “foreign currency credit continued to grow during 2017, with US dollar credit rising by 8 per cent to US$11.4 trillion and euro credit by 10 per cent to €3 trillion (US$3.57 trillion),” the bank wrote. US dollar credit to emerging market economies rose by 10 per cent to US$3.67 trillion in the year to end-2017, it added. 

This US-dollar dominance is critical, as the main currency moving into any markets, not just emerging markers, will also be the main mover out of them. 

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And US dollar investors moving into emerging markets are not altruistic. Their motivation is to secure higher returns, in exchange for perceived higher risk, than are currently available in the US or elsewhere. If the balance shifts in the US’ favour, capital flows will reverse. 

And the balance is shifting. Friday’s US jobs and earnings data might not have been particularly exciting, even if the US headline unemployment figure hit 3.9 per cent for the first time since December 2000, but should arguably be enough to keep the Federal Reserve on track for a rate hike in June with further rises in the pipeline. 

A forward-looking US central bank cannot also fail to have noticed Thursday’s release from the National Federation of Independent Businesses that showed that, in April, 57 per cent of polled businesses were hiring, a rise of 4 percentage points from March. A net 33 per cent of small businesses are raising worker compensation, the highest monthly reading since May 2000. 

The prospect of higher US wages, combined with the effects of US tax cuts, should leave the US consumer with greenbacks to spend and, with consumption making up some 70 per cent of US gross domestic product, that’s something the Fed can’t ignore. 

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The existence of tighter US financial conditions, compared to those in Hong Kong, have already and rationally been expressed in a weakening Hong Kong dollar. That has elicited a policy response, as it should, under the linked exchange rate system, lending itself to higher local interest rates and bridging the gap with the US. 

But a measured decline in the value of the Hong Kong dollar is a world away from what can happen in other emerging markets when investors decide to pull out their money and get back into greenbacks. Not all central banks have the credibility, or even the means, of the Hong Kong Monetary Authority to address undesired local currency weakness. 

It seems an age ago now but, in June 2017, Argentina could issue a US dollar-denominated 100-year government bond receiving US$9.75 billion of orders for a US$2.75 billion issue with a coupon of 7.125 per cent. 

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Last Friday, with inflation in Argentina in April at 25.4 per cent, the local central bank had to raise its benchmark interest rate to 40 per cent in an attempt to arrest the pace of the peso’s decline. It had fallen 7.83 per cent versus the US dollar on Thursday alone. 

Friday also saw the Turkish lira hit a record low against the US dollar, beset by 11 per cent year-on-year inflation and, among other factors, investor concerns that Turkey’s central bank could come under political pressure not to tighten monetary policy as far as they might. 

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In these two situations, local problems are the major drivers of local currency weakness but there is also the common denominator, as in Hong Kong, that tighter US monetary policy is now helping the US dollar. 

Markets can behave like predators, pursuing what they perceive as the weakest prey first. Argentina and Turkey are currently filling that not-to-be-envied role in the wider emerging markets space. But they probably won’t be the last. 

Billions of US dollars of capital have flowed into emerging markets in recent years but the tide may be turning. It would be easy to just characterise Argentina and Turkey as special cases but that would be naive. As US yields continue to rise, emerging market currency weakness may well become more general.

Neal Kimberley is a commentator on macroeconomics and financial markets