The world works under the dollar standard, the currency par excellence, not only because raw materials are quoted in dollars but many countries borrow dollars if they are at an attractive price, that is, a low interest rate compared to the local currency.
This reality leads to decisions on monetary policy undertaken by the Federal Reserve that are crucial not only for the US economy itself but also for many other countries.
Investors tend to worry about the sustainability of debt in US dollars in those emerging market economies that are especially dependent on this currency such as Argentina, the Philippines, Indonesia, Turkey and Brazil.
Recently, we have seen how there has been a sharp depreciation of the Argentine peso, the Turkish lira, and the Brazilian real, being the three currencies that have depreciated the most so far this year. So what is happening? ?
Why the rise of rates of the Federal Reserve crushes the emerging countries?
In the first place, it is necessary to understand why there are strong devaluations in emerging countries. When interest rate hikes are carried out by the Federal Reserve, one must always keep an eye on the evolution of emerging markets because certain complications in their development usually occur.
On the one hand, for the United States to increase its interest rates means that money will be better remunerated here, so that there can be a reversal of capital flows. Because many emerging countries have current account or fiscal deficits, and depend, to a large extent, on external flows to finance them. Once these flows disappear or are reduced, and are directed to the dollar, serious imbalances occur in the evolution of emerging countries.
The other relevant issue is that many emerging countries choose to finance themselves via dollars, taking advantage of the low interest rates that the Federal Reserve has promoted in recent years.
When there is a reversal of capital flows to the United States, there is an appreciation of the US currency in the local currency, therefore it is more difficult to cover the debt denominated in dollars with the exchange rate being devalued.
Therefore, those countries that depend on external financing are especially sensitive to the monetary policy decisions of the Federal Reserve, and therefore, there are strong volatilities in the emerging markets that are most linked to the dollar.
And therein lies the problem … We have the Fed raising interest rates and, at the same time, around $249 billion dollars must be reimbursed or refinanced over the next year. That is a legacy of a decade of debt bingeing during which emerging markets more than doubled their dollar loans, ignoring the many lessons of the history of the Latin American debt crisis of the 1980s, the Asian financial crisis of the ’90s and the Argentine default at the beginning of the century.
Argentina: The Argentine peso plunged 25% so far this year
Argentina has maintained in recent years a weakness in terms of current account deficit and lack of clarity in the development of its monetary policy in times of currency intervention. For Argentina, the debt denominated in dollars amounts to $150 billion.
There is a fact that is especially relevant in Argentina. Argentine banks have high levels of net open positions in currencies, that is, dollar loans are not offset by dollar deposits. The net open positions of Argentine banks are at 14%.
This situation has motivated the fall of the peso. Argentina raised the overnight interest rate to the highest in the world and sold some of its currency reserves. The Central Bank of Argentina raised its interest rates for the third time to a surprising 40%. In addition, it has had to sell $8 billion of its reserves since early March in its failed attempt to stop a 25% drop in the value of the peso.
This is not the first time that this has happened in Argentina. In 2001, concern over the devaluation of the peso caused spikes in overnight interest rates, triggering bond spreads between Argentine and US debt, which accelerated to become a real attack on the country’s banking system, and many rushed to withdraw money from the country’s financial institutions.
Turkey: The Turkish lira lives a depreciation of 17%
Turkey has large deficits in the current account balance, the increase in external debt and the consequent large refinancing needs in the context of higher political risks and the increase in global interest rates-
As can be seen in the following graph, Turkey’s current account balance has soared in the last decade. In the first three months of 2018, the current account deficit jumped to $16.3 billion dollars from $8.3 billion in the same period of 2017.
Although the Government’s own external debt needs are relatively low, the country has very significant external financing needs, given the considerable deficits of the current account balance, the maturity of long-term debt and high levels of short-term debt. term. This external exposure has continued to grow over the past year and is expected to continue to do so.
The country’s foreign exchange reserves are very low in comparison with these needs, it is expected that the country’s External Vulnerability Indicator will rise to more than 200%, which is extremely high and points to a growing exposure to changes in sentiment of international investors.
This combination leads to a sharp depreciation of its currency, the Turkish lira fell 17% against the dollar. It should be noted that Turkey’s political risks increase its vulnerability to external shocks, with the convergence of risks in the geopolitical arena and internal politics.
As if there was little uncertainty for the lira, on the domestic front, the government’s legal repression since the failed coup of July 2016 has had a negative effect on the investment climate and relations between Turkey, the United States and the EU.
Brazil: The Brazilian real loses 11%
When the former populist president of Brazil, Luiz Inacio Lula da Silva, was jailed for corruption, markets were expected to celebrate the end of the leftist leader’s hopes of return in this year’s elections.
But instead of rebounding, Brazil’s currency, the Brazilian real, headed in the opposite direction, touching its lowest levels since 2016. The aforementioned dollar repatriation factors come into play due to the rise in rates but also, the liquidation by the central bank of billions of dollars of swaps that were used by investors as coverage.
During Rousseff’s presidency, the central bank sold $114 billion dollars in foreign exchange swaps to help soften the volatility of the real, driven by domestic political uncertainty and doubts about the monetary policy of the United States. Even so, the Brazilian real lost 11% against the dollar so far this year.
The swaps provided coverage to investors who bought assets denominated in Brazilian reais to take advantage of the carry trade – a strategy to sell a currency with a low interest rate and buy another with a higher interest rate.
However, one of the strengths of Brazil is the large amount of foreign exchange reserves available, which gives its monetary authority more than enough margin to avoid a collapse of the Brazilian real, selling dollars and buying their currency.