Emerging Market FX: Policy Differentials Drive Movements
The largest differences in policy are not seen between developing countries, but among emerging countries. This is driving movements in emerging market FX.
Emerging market are running tighter policies
Emerging markets as a whole are running much less easy monetary policy, lower budget deficits relative to output, and are generally trying to keep sound currencies (i.e., relatively high real interest rates on cash and bonds with minimal money “printing”).
Emerging markets really have no choice, given they have low global demand when it comes to holding their savings – i.e., holding the currency in the form of bonds. Having overly easy monetary policy is an easy way to lead to a balance of payments issue, with more money leaving the country instead of coming in.
Mexico, for example, did not handle the Covid-19 pandemic like the US did. While the US cut interest rates, re-adopted asset buying programs, and printed lots of money with new spending programs, Mexico did little of that.
The US is accustomed to having the world’s top reserve currency, so they have little reservation in doing aggressively printing. There’s demand for some (but not all) of the debt.
For Mexico, when there’s little demand for their debt, it feeds more directly into inflation and/or higher credit costs. As a result, they’re choosing to run tighter policy. This, in turn, has helped their currency.
In terms of monetary reputation, the US is held in far greater regard globally. But in practice it’s a different story with one addicted to negative real interest rates because of its intractable financial problems (the US) and Mexico running positive real rates.
Many countries in Southeast Asia are another example of countries with mostly sound policies and large, secular productivity growth rate advantages over the US and other developed countries.
Output and inflation trade-offs
It is popularly known among traders, investors, economists, and other market participants that central banks face a trade-off between output and inflation when they pull their policy levers to change interest rates and liquidity in the financial system.
But the severity of this trade-off depends. It is more difficult to manage when capital is leaving the country. Conversely, it’s easier to manage when capital is coming into the country.
Capital flows coming into a country allow it to increase its foreign exchange reserves, lower interest rates without stoking inflationary pressure, and/or appreciate its domestic currency, depending on how the central bank wants to use this advantage.
When capital moves out, the central bank’s job is accordingly more difficult. It faces either higher interest rates, a weaker currency, and/or will need to expend its finite supply of FX reserves.
In a capital outflow scenario, less growth is achieved per each unit of inflation, and vice versa when capital is coming in.
Can emerging market FX excel in this environment?
Emerging market currencies are likely to do better as a whole when they’re running relatively sound fiscal and monetary policies. This is true for any country, but it’s particularly true in the post-Covid world with developed markets printing their way out of their problems and emerging markets taking a totally different path (e.g., social measures to fighting the virus, taking big drops in their economies).
On the contrary, developed markets are in a perpetual printing phase because of their debt and other IOUs that need to be monetized. These are not only debt-based but related to pensions, healthcare, and other unfunded liabilities that are increasingly requiring cash commitments to fund them.
Currency devaluation helps create relief and at least pay them in nominal terms. It also helps relieve foreign debtors who generally have lots of liabilities denominated in the world’s top reserve currency (USD).
So, circumstances are very different between developing and developed markets due to the very different ways they’re pulling their policy levers.
Countries that can benefit from a stronger US economy in nominal terms but don’t require much in the way of US dollar liquidity are likely to benefit the most – at least in the short term.
Over the long run, the big issue is:
- the large-scale printing of USD (and to a lesser extent, other currencies that are widely considered reserves)
- the reliance on negative real interest rates, and
- those influences on the desire to hold dollars
In addition, while USD reserve holdings are around 60 percent of all global holdings, the US economy is only about 20 percent of global economic activity and slowing.
Other measures working against USD holdings – and therefore the value of the dollar over the long run – include:
- US debt market capitalization relative to the capitalization of other global debt markets
- The asset allocation that international investors would want to hold in order to be prudently balanced
- The reserve currency holdings that would be suitable to meet the needs of trade and capital flow funding
The US’s weaponization of the dollar (e.g., sanctions) to help get what it wants is another knock against the dollar. Naturally, those subject to those sanctions want to circumvent them. To do so, you need another system that falls outside of that.
China is coming up to challenge the US along various fronts, including:
…and wants to bring along the internationalization of its currency.
Moreover, Fed policymakers would be happy to get a weaker dollar in time. It’s the only way the liabilities will ever be paid. It’s impossible to grow out of them.
Holders of dollar assets – especially debt assets – will likely want to ensure that they’re not overly concentrated in them through cash and bond alternatives and inflation protection assets.
Portfolio strategy will need to change in light of the way the world is going. Dollar and dollar debt assets had a great run between 1981 and 2020 with the compression of interest rates that provided a tailwind to the values of all financial assets impacted by an interest rate (bonds, stocks, real estate, private equity, venture capital).
That formed a 40-year period that encapsulated the entire lives (or beyond) of most markets participants, which often means an extrapolation of past conditions and a desire to continue what has worked even when things change.
Things like a stocks-centric or 60/40 stocks/bonds approach is not likely to be as good of a strategy going forward. Non-dollar and non-debt assets will become more prized for yield and broader diversification, which can include emerging market FX and EM debt and equity assets.
Dollar devaluation is not necessarily a short-term concern, but over the long run it will be, and it can be a short-term or medium-term concern if the US’s easy fiscal and monetary policies get pushed too far.