Is another EM crisis on the horizon?
Here, we analyse the risks posed by US dollar strength for emerging market economies.
Alongside the human toll, only now beginning to climb in many emerging markets (EM), the coronavirus pandemic poses another crisis risk for EM. A global flight to safety, impacting all risk assets, entails additional macroeconomic risks for economies heavily reliant on US dollar financing. While all economies are under stress at this moment, EM economies face additional unique pressures to which their developed market peers are not subject.
Dollars are becoming increasingly hard to come by as global trade shrivels amidst the shutdowns, tourism collapses, banks and other international lenders become unwilling to lend given the outlook and increased repayment risk, and portfolio flows dry up in the global dash for cash.
Why dollars are important to EM
The currency has become increasingly dominant in both global trade and finance. The bulk of EM trade, for example, is invoiced in dollars, meaning economies could begin to struggle to buy essential imports of food and energy.
Meanwhile, turning to credit, the dollar is dominant in many EM financial systems. In general, it is clear that a more expensive dollar will have repercussions for EM borrowers.
How the Fed is providing support to some EM
On this occasion, the Fed has been quick to expand swap lines with other central banks, effectively swapping dollars for other currencies for an agreed time period. Those central banks can then supply dollars to their own financial systems, reducing the strain on markets.
While this has certainly calmed nerves in developed markets, essentially closing the gap between what foreign and domestic borrowers of dollars must pay, only a few EM are lucky enough to have access to a Fed swap line. If access to dollars is curtailed, central banks in EM will have to fall back on their reserves.
Luckily, most EM central banks have adopted a monetary policy framework combining inflation targeting with FX reserve accumulation. This means they have more leeway to allow currency depreciation to bear the brunt of macroeconomic adjustment, thanks to low inflation expectations anchored by years of sound policymaking, and greater buffers to cushion the economy.
Which EM are more prone to risks?
The question for investors might then be which EM economies have sufficient resources to survive in the face of so many coincident pressures. Economies will need hard currency reserves sufficient to cover lost revenues from exports, to cover essential imports, counter capital flight, repay or rollover maturing debt and to at the very least smooth the volatility in their exchange rates.
The IMF has provided a methodology for an assessment of reserve adequacy incorporating these considerations, based on the experience of past crises. We show where major EM economies stand today relative to this measure of reserve adequacy, inclusive of the swap line support from the Fed, where applicable.
Note, however, that this measure of reserve adequacy assumes economies are happy to allow their currencies to absorb the shock. A fixed exchange rate regime, or even a managed float, would see a downward revision of a given economy’s level of preparedness. The measure also assumes no capital controls, which would work in the opposite direction.
The markets to the left of the chart seem to be in a better position to defend their currencies and might be expected to see less pronounced falls than those on the right, which will have little option but to stand aside unless they implement some form of capital controls. The longer the disruption to the global economy, and its financial system, continues, the more likely such a path becomes.
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