The Emerging Market Economies and the Appreciating Dollar
by Joseph Joyce
The Emerging Market Economies and the Appreciating Dollar
U.S. policymakers are changing gears. First, the Federal Reserve has signaled its intent to raise its policy rate several times this year. Second, some Congressional policymakers are working on a border tax plan that would adversely impact imports. Third, the White House has announced that it intends to spend $1 trillion on infrastructure projects. How all these measures affect the U.S. economy will depends in large part on the timing of the interest rate rises and the final details of the fiscal policy measures. But they will have consequences outside our borders, particularly for the emerging market economies.
Forecasts for growth in the emerging markets and developing economies have generally improved. In January the IMF revised its global outlook for the emerging markets and developing economies (EMDE):
EMDE growth is currently estimated at 4.1 percent in 2016, and is projected to reach 4.5 percent for 2017, around 0.1 percentage point weaker than the October forecast. A further pickup in growth to 4.8 percent is projected for 2018.
The improvement is based in part on the stabilization of commodity prices, as well as the spillover of steady growth in the U.S. and the European Union. But the U.S. policy initiatives could upend these predications. A tax on imports or any trade restrictions would deter trade flows. Moreover, those policies combined with higher interest rates are almost guaranteed to appreciate the dollar. How would a more expensive dollar affect the emerging markets?
On the one hand, an appreciation of the dollar would help countries that export to the U.S. But the cost of servicing dollar-denominated debt would increase while U.S. interest rates were rising. The Bank for International Settlements has estimated that emerging market non-bank borrowers have accumulated about $3.6 trillion in such debt, so the amounts are considerable.
In addition, Valentina Bruno and Hyun Song Shin of the BIS have examined (working paper here) a “risk-taking” channel of U.S. monetary policy that links exchange rate movements to cross-border banking flows. In the case of an appreciation of a foreign currency, domestic banks in the affected countries channel funds from global banks to firms with local currency assets that have risen in value. A domestic currency depreciation in response to U.S. monetary policy will lead to a contraction in such lending.
Jonathan Kearns and Nikhil Patel of the BIS have sought to determine whether the “financial channel” of exchange rates offsets the “trade channel.” The sample of countries they use in their empirical analysis includes 22 advanced economies and 22 emerging market economies, and the data for most of these countries begins in the mid-1990s and extends through the third quarter of 2016. They use two exchange rate indexes, where the indexes measures the foreign exchange values of the domestic currency, in one case weighted by trade flows and the second by foreign currency-denominated debt.
Their results provide evidence for both channels that is consistent with expectations: the trade-weighted index has a negative elasticity, while the debt-weighted index has a positive linkage. For 13 of the 22 emerging market economies, the sum of the two elasticities is positive, indicating than an equal appreciation of the domestic currency would be expansionary. The financial channel is stronger for those emerging market economies with more foreign currency debt.
Does this indicate that further appreciation of the dollar will lead to the long-anticipated debt crisis in the emerging markets? When Kearns and Patel replaced the debt-weighted exchange rate index with the bilateral dollar rate, they found that the debt-weighted index does a better job in capturing the financial channel than the dollar exchange rate alone. The other foreign currencies in the debt-weighted index included the euro, the yen, the pound and the Swiss franc, so a rise in the dollar is not as important when the debt is denominated in the other currencies.
Domestic policymakers in the emerging market countries seem to have done a good job in restraining domestic credit growth, which is often the precursor of financial crises. There is one significant exception: China. One recent estimate of its debt/GDP ratio placed that figure at 277% at the end of 2016. The government is attempting to slow this expansion down without destabilizing the economy, which now has a growth target of 6.5%. What happens if the dollar appreciates against the renminbi as it did last year, when China used up a trillion dollars in foreign exchange reserves in an attempt to slow the loss in value of its currency? About half of China’s external debt is denominated in its own currency, so it has less to fear on this score than do other borrowers.
A team of IMF economists that included Julian Chow, Florence Jaumotte, Seok Gil Park, and Yuanyan Sophia Zhang examined in 2015 the spillovers from a dollar appreciation. They noted that many emerging market economies are currently less vulnerable to a dollar appreciation than they were during previous periods. However, they also reported that some countries in eastern Europe and the Commonwealth of Independent States have short positions in dollar-denominated debt instruments. They investigated corporate borrowing, including debt denominated in foreign currencies, and performed a stress test analysis based on higher borrowing costs, a decline in earnings and an exchange rate depreciation to see which countries had the most vulnerable firms. They reported that increases in foreign exchange exposure would be largest in Brazil, Chile, India, Indonesia and Malaysia. They concluded their report: “Should a combination of severe macroeconomic shocks affect the non financial sector, debt at risk would further rise, putting pressure on banking systems’ buffers, especially in countries where corporate and banking sectors are already weak. “
Another team of Fund economists, led by Selim Elekdag, also investigated rising corporate borrowing in the emerging market economies in the October 2015 Global Financial Stability Report. They attributed the rise in corporate debt in these countries to accommodating global monetary conditions. Consequently, these firms are quite vulnerable to changes in U.S. interest rates.
Some analysts see signs of a “virtuous cycle” in many emerging market economies. The motivating factors range from pro-growth policies in India to China’s ability (to date) to avoid a severe slowdown. But these economies are quite vulnerable to external developments. The Federal Reserve recognize this, and takes the foreign impact of its policies into account. But no such assurance comes from the rest of the U.S. government. President Trump’s fulfillment of his promise to disrupt the normal policy process in Washington will have a broad impact outside the U.S. as well.
cross posted with Capital Ebbs and Flows
I’ll believe that Trump is going to spend lots of money on infrastructure when I see it. So far what has been put out there beyond a lot of rhetoric has been a half-baked plan to provide tax breaks for companies that invest in infrastructure, with the apparent goal of privatizing that infrastructure so that when you cross one of their bridges or drive on one of their highways, you will get to pay a toll to them. Will this bring about a lot more or improved infrastructure? I am not holding my breath, especially when what we need a lot of is simply fixing up old infrastructure. Will companies be allowed to charge tolls for having fixed potholes in streets?
My guess China is the next credit crunch. This will trigger the dollar to collapse and China will try and come in and boost their own currency(boosting the dollar) making everything worse. Then the US will have a credit seize up likely in the non-Wall Street component of the financial system, collapsing most of the regional banks.
The rising dollar is actually the opposite of what you think. It is going up to handle the stresses of controlling capital flight. It makes maintaining the peg easier, because if it would fall again, ugly ugly. That is why team Trump is supporting a strong dollar now. They know the shit is going to hit and the minister of information needs to be in control.
The Rage —-
The dollar’s rise in relative international value is due to a relative increase in demand for U.S. dollar denominated assets which in order to purchase them requires foreign currency and asset owners have sell their currency to purchase dollars. This increases the supply and reduces demand for foreign currency and decreases the supply and increases demand for U.S. dollars… resulting in a devaluation of non-US currencies and an appreciation in value of U.S. dollars.
Some of the currency trades are surely speculative in the short term, but most are backed by real assets (bonds, shares of U.S. stocks, oil, real property).
So I don’t understand where your statement makes sense to me… that:
“The rising dollar is actually the opposite of what you think. It is going up to handle the stresses of controlling capital flight.”
Whose controlling what capital flight? If anything foreign capital owners and national treasuries or central banks are trying to stem capital flight to US dollars… but evidence is that whatever mechanisms they’ve been using I that attempt have been far from successful… the dollar’s value is up by 23% – 24% of which the most recent 4% – 5% rise (to index 101) occurred after Trump’s election.
So I can’t figure out why you say that the dollar value is going up to “control capital flight”.
Barkley Rosser —
You’re more than likely correct on Trump’s $1 trillion “plan” for infrastructure spending… which Ryan says would have to be $40 in private funding for every federal dollar for congress to give it the go-ahead.
If Ryan’s thinking prevails then private funding would be 97.5% of the $1 trillion, which also means the private funds have to return a profit on that spending. At a nominal 8% profit per year then taxpayers will end up footing the bill for both principle and profit to private enterprises … e.g. costing taxpayers over $2 trillion over10 years instead of $1 trillion.
The exact numbers can be debated, but the point is that most of infrastructure demand is not that which private enterprise finds profitable (other than toll roads and toll bridges), so it’s not at all clear that a $1 trillion funding over 10 years will even come close to occurring in fact.
The present right wing congress is not hell-bent for increasing the deficits either .. though they will by tax cuts and huge increases in defense spending…they never fail in this. so to get much if anything in public funding for infrastructure, it will have to come out of health care, welfare, EPA, SEC, and IRS funding.
In short, like you, I wouldn’t expect Trump talk to amount to anything except talk (lies?).in terms of increasing U.S. GDP, but if private funding is given sufficient incentives then it will drive the value of the dollar up even more… with a lot of private funding coming from foreign capital, with the taxpayer ‘s footing the private profits and paying for them for decades… while not owning them either.
Look no further than Ayn Rand for the playbook.. .