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Wednesday, 21 September 2022

What the USD’s rally means for the global economy + emerging markets

The USD has been on a tear this year. That strength is problematic for emerging markets and the global economy at large. Spurred by successive interest rate hikes from the US Federal Reserve as the central bank pulled out all the stops to cap soaring inflation, the greenback has been rallying since the beginning of the year, with the Bloomberg USD Spot Index up some 12% year-to-date. The currency’s rise, while beneficial in some ways for the US economy, is a growing source of concern for the global economy as a whole, and emerging markets in particular.

First thing’s first: Why the USD has been rallying so much to begin with: The Fed kicked off a monetary tightening cycle at the beginning of the year to quell record-high inflation. Although the rest of the world’s central banks — including Egypt’s — have also begun raising interest rates, the US is outpacing most, making the USD an ever-more attractive safe haven. The Fed is widely expected to announce today its third successive 75-bps hike when the meeting wraps tomorrow. Higher interest rates “sparked selling in stocks and bonds, driving up the two-year Treasury yield, which typically moves with expectations for Fed policy,” leading investors to seek shelter in the USD, the Wall Street Journal notes.

Additionally, there are several other fundamentals underpinning the USD, including the strong jumping-off point from the US’ covid-19 macroeconomic response and the fact that the US is not exposed to “egregiously expensive foreign energy,” former Treasury Secretary Lawrence Summers told Bloomberg. “All of those various factors are making [the US] a safe haven, a mecca for capital — and that’s causing resources to flow into the USD,” Summers said.

What does all this mean for the US? It depends whether you’re on Wall Street or Main Street. For Main Street — finance-world speak for smaller businesses that reflect the broader or real economy — a strengthening USD means higher purchasing power for US consumers thanks to imports being cheaper. But on Wall Street, investors are growing increasingly concerned that the strengthening greenback will weigh on US corporate earnings and the global economy, particularly as emerging markets reckon with higher debt costs and a weaker lower currency, the Wall Street Journal notes.

The outlook for emerging markets looks far bleaker: A strengthening USD is “a major headwind for local currency assets in emerging markets,” particularly as the currency’s appreciation comes at the same time as a slowdown in global economic growth and higher interest rates in developed markets, Tellimer Research Strategy and Head of Equity Research Hasnain Malik wrote in a note.

The upside: Equities and currencies in emerging markets both “look cheap,” Malik writes.

The caveat: Currencies being cheap isn’t enough, and must be “accompanied by credible monetary policy and a manageable level of external account pressure,” he notes. And for many emerging markets, any upside from having a weaker currency and therefore more attractive export prospects is outweighed by the higher cost of USD borrowing, the Economist says.

This is all coming at a time when debt piles are quite large, especially because of covid-era borrowing: There is currently some USD 83 bn-worth of USD-denominated debt across emerging markets that will by due by the end of next year, according to data from the Institute of International Finance cited by Brookings. And many markets aren’t ready to face that debt pile, University of Chicago’s Booth School of Business finance professor Raghuram Rajan tells the Wall Street Journal. “Many countries have not been through a cycle of much higher interest rates since the 1990s. There’s a lot of debt out there augmented by the borrowing in the pandemic,” which is expected to “widen” the stress in emerging markets.

What happens now? Further USD appreciation could be “the straw that breaks the camel’s back, cautions Oxford Economics’ head of emerging markets research. “You’re already getting frontier markets on the tipping point toward crisis, the last thing they need is a strong USD.” Economists and policymakers are considering the possibility of a repeat of the 1985 Plaza Accord, which saw the US, France, West Germany, the UK, and Japan coordinating to depreciate the USD relative to the JPY and Germany’s Deutsch mark. However, the possibility of such a coordinated effort appears to be relatively slim, as the contemporary global economy and political dynamics are vastly different from where they were some four decades ago.

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