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Will Emerging Markets Face a New Currency Crisis? A Look at the Risks and Reassurances

In this round of the Fed’s interest rate hike cycle, the financial markets of emerging market (EM) economies have been operating smoothly as a whole and have not repeated the cycle of “Fed interest rate hike – US dollar appreciation – capital outflow – currency crisis”. However, in 2024, as the Federal Reserve’s interest rate cuts continue to be postponed, U.S. bond interest rates and the U.S. dollar exchange rate continue to hit new highs during the year, putting the exchange rates and risk asset prices of some developed countries and emerging market economies under pressure. Is a new round of “currency crisis” on the way? Where is the most vulnerable link?

Is a new round of “currency crisis” and “debt crisis” in emerging market countries on the way?

Since April, emerging market stock markets have plummeted, exchange rates have been under pressure, and the probability of sovereign debt defaults has also increased. There seems to be a precursor to a “currency crisis” and a war without smoke seems to be coming.

In terms of stock markets, from April 8 to 19, the MSCI Latin America, Asia, Europe, Africa and Middle East emerging market indexes fell by 6.3%, 4.1% and 3.4% respectively. Among them, the Turkey, Kuwait and Malaysia indexes led the decline, falling by 5.9% and 3.4% respectively. 5.6% and 5.6% (Figures 1 and 2).

In terms of exchange rates, from April 8 to 19, the nominal U.S. dollar index against emerging markets rapidly appreciated by 1%, while the Colombian peso, Indonesian rupiah, and Brazilian real depreciated rapidly against the U.S. dollar by 3.9%, 2.5%, and 2.1%. In the week from the 15th to the 19th, the U.S. dollar index rose, while other currencies diverged against the U.S. dollar: the U.S. dollar index rose 0.09% to 106.11, the euro appreciated 0.14% against the U.S. dollar, the pound depreciated against the U.S. dollar by 0.64%, the Japanese yen depreciated against the U.S. dollar by 0.93%, and the Canadian dollar It appreciated by 0.18% against the US dollar, while the Norwegian krone depreciated by 1.01% against the US dollar.

Most major emerging market currencies also fell against the U.S. dollar during the same period: the Turkish lira depreciated 0.4% against the U.S. dollar, the Indonesian rupiah depreciated 0.54% against the U.S. dollar, the Philippine peso depreciated 1.65% against the U.S. dollar, the Brazilian real depreciated 1.6% against the U.S. dollar, and the Korean won appreciated against the U.S. dollar. 0.43%. A strong dollar weighed on emerging market currencies.

The risk of sovereign debt default in some countries and regions has also increased significantly. Currently, the risk of sovereign debt default in Lebanon, Turkey, and Hungary within one year is 26.1%, 17.2%, and 5.7% respectively. Emerging markets seem to be showing signs of “crisis”.

The main reason for the recent pressure on emerging markets may be the renewed strength of the US dollar under the “reflation” trade. Since April 8, the U.S. dollar index has risen sharply by 1.9%, which has led to the return of assets and has generally put emerging market currencies under pressure.

The strength of the US dollar is mainly affected by two aspects. First, the risk of “reflation” has increased. The U.S. de-inflation process has already seen a “death cross”. The downward slope of core CPI has slowed down significantly in the past six months, and the month-on-month growth rates in one month, three months and six months have all exceeded the year-on-year growth rate. , indicating that the downward resistance is getting stronger. Second, the economy is still resilient, and the trend of an economy not in recession (No Landing) is gradually becoming clear. Since the beginning of 2024, against the backdrop of countries continuing to destock and financial conditions continue to loosen, the global manufacturing industry has revived. Based on the causal relationship between leading indicators and financial conditions and manufacturing PMI, the recovery trend of the US manufacturing industry can continue before financial conditions tighten again.

In addition, geopolitical and other factors have intensified recent risks in emerging markets. As frictions between Israel, Palestine, and Iran intensify, the tense geopolitical situation in the Middle East has also had a significant impact on the risk appetite of global investors. Since April 8, the S&P 500 Implied Volatility (VIX) and U.S. Bond Market Implied Volatility (MOVE) indices have increased by 23.2% and 12% to 18.7 points and 111.3 points respectively. The significant rise in risk aversion has not only pushed up the prices of safe-haven assets such as gold, but also accelerated the outflow of funds from emerging markets, exacerbating risks in emerging markets.

Historical currency crises: Fundamentals and financial conditions are the deciding factors

The market’s concerns are groundless. Several emerging market currency crises in history did occur against the background of the Federal Reserve raising interest rates, such as the Latin American debt crisis in the 1980s, the Mexican peso crisis in 1994, and the Asian financial crisis in 1997. wait. Even if the Federal Reserve launched Taper (taper) in 2014 and gradually reduced the scale of asset purchases, it would be enough to trigger a sharp depreciation of emerging market currencies. But will high-intensity interest rate hikes inevitably trigger a crisis in emerging markets?

In fact, the Latin American debt crisis in the 1980s was related to factors such as its excessive foreign debt ratio and insufficient foreign exchange reserves. This round of crisis began in August 1982, when Mexico announced that it could not repay its foreign debt, which kicked off the Latin American debt crisis. The crisis subsequently spread to Brazil, Argentina, Venezuela and other Latin American countries, and lasted for several years. The reason is that in addition to the rapid strengthening of the U.S. dollar index stimulated by then Federal Reserve Chairman Volcker’s tightening, Reagan’s tax cuts and supply-side reforms, the fragility of Latin American countries’ own financial conditions seems to be more critical. During the early depreciation stage of the US dollar, hot money flowed into Latin American countries in large quantities, resulting in excessive foreign debt ratios. However, these countries themselves lacked foreign exchange reserves. After the “oil crisis” gradually subsided, European and American countries emerged from stagflation, and the attractiveness of the US dollar increased again. The return of capital led to the outbreak of the Latin American debt crisis.

The Mexican peso crisis in 1994 was mainly caused by the large inflows and outflows of hot money, and the short-term strength of the US dollar was only the trigger. On December 20, 1994, Mexico announced the devaluation of the peso, triggering a currency crisis. The crisis also spread rapidly, causing an impact on the financial markets of other Latin American countries, known as the “tequila effect.” It is true that the background to the crisis was that from February to November 1994, the Federal Reserve raised interest rates six times by a total of 250 basis points. A series of fast and urgent interest rate hikes caused the U.S. dollar to appreciate rapidly starting from October 26, 1994. Mexico The peso remains under pressure. But the underlying reasons behind the crisis were Mexico’s early massive inflows and outflows of foreign capital, its thin foreign exchange reserves, and the turbulent political situation at that time. As early as 1992-1994, Mexico had an average annual inflow of US$25 billion-35 billion in hot money, laying the groundwork for this crisis.

During the Asian financial crisis in 1997-1998, Southeast Asian economies also faced problems similar to Latin American countries: excessive foreign debt ratios and insufficient foreign exchange reserves. The crisis began on July 2, 1997, when the Thai government announced a floating range for the baht. Subsequently, the baht depreciated sharply and the crisis spread rapidly. Currencies and stock markets in Indonesia, South Korea, Malaysia, the Philippines and other places plummeted. This round of “strong dollar” occurred in the context of Clinton’s reforms. After Clinton took office, he effectively reduced the U.S. fiscal deficit. At the same time, foreign capital has poured into U.S. stocks amid the Internet boom, and the economic slowdown in Southeast Asia has further weakened its attractiveness to foreign capital. The hidden dangers of “excessive foreign debt ratio and insufficient foreign exchange reserves” in the early stage were ignited during this period. Under the impact of short-selling funds, various parts of Southeast Asia successively abandoned fixed exchange rates, and the exchange rates plummeted.

In the currency crisis of resource countries in 2015, commodity prices plummeted, and the deterioration of their current account conditions was the fundamental reason. In this round of currency crisis, the Argentine peso, Brazilian real, South African rand, Colombian peso, Turkish lira and Malaysian ringgit, which have implemented floating exchange rates, depreciated by 34.2%, 32.9%, 25.4%, 24.5%, 20.3% and 20.3% respectively. 18.6%. The rise in the U.S. dollar index at that time occurred against the backdrop of divergent monetary policies in Europe and the United States. The Federal Reserve started Taper in 2014, while the European Central Bank still maintained an easy monetary policy. The crisis was triggered not only by the rapid strengthening of the U.S. dollar, but more importantly by the plummeting commodity prices, which caused the resource countries’ trade conditions to rapidly deteriorate and the scale of exports to shrink sharply. This resulted in a massive outflow of foreign capital of US$83.46 billion, and the currencies of the resource countries all Significant depreciation.

Generally speaking, several currency crises in emerging markets in history did occur against the background of the Federal Reserve raising interest rates. However, this was only a triggering factor. The fundamentals and financial conditions of emerging markets were the decisive factors.

“High interest rates – strong US dollar” is a short-term stress test, while “currency – debt crisis” is still a tail risk

The driving factors of hot money flows in emerging markets can be divided into three categories: push, pull and pipe.

Push refers to external factors, that is, factors that prompt investors from six developed economies (Advanced Economies, referred to as “AE”) including the United States, the Eurozone, and the United Kingdom to invest in developing economies. It is related to the supply of funds, such as the Monetary policy, investor risk preference, US dollar exchange rate, etc. When AE implements loose monetary policies, investor risk appetite increases, the economy slows down, commodity prices rise, or the US dollar faces depreciation pressure, funds flowing into EM, that is, emerging markets, will increase.

Pull refers to internal factors, that is, attraction, including cyclical factors and structural factors. In practice, investors usually focus on key comprehensive indicators of these factors, such as credit ratings. Channel refers to the infrastructure of the financial market and is the medium for capital circulation, including not only financial intermediaries, but also financial systems, rules, etc.

The driving force of”hot money” flows in emerging countries

Capital flow is the result of the combined forces of these three factors. On the supply side, there is ample liquidity and high risk appetite; on the demand side, the economic fundamentals are sound, the finances are sound, the financial infrastructure is perfect, the market is open, and international financial institutions prefer cross-border investments. In an environment of financing activities, the scale of global capital flows will be considerable. Relatively speaking, scale is mainly determined by push and pull, and volatility is mainly determined by channels. Data based on surveys by the Bank for International Settlements (BIS) found that both AE and EM banks believe that AE’s monetary policy is the most important thrust, which is consistent with the substantial increase in EM capital inflows in the post-crisis era. In terms of pull, EM’s capital account openness and sovereign credit rating have significant positive effects. For different forms of capital flows, the same push or pull factor has the same influence direction, but there are differences in the degree and significance of the influence.

At present, from the perspective of economic fundamentals, monetary policy direction, capital liquidity, excess reserve ratio, etc., most emerging markets may not need to worry.

From a fundamental point of view, during this round of Fed interest rate hikes, the manufacturing boom of emerging market economies is better than that of developed economies, and is still improving at the margin; from a monetary policy point of view, some emerging markets have entered the interest rate cut cycle ahead of schedule. , leaving room for “precautionary interest rate hikes” to prevent crises; from the perspective of capital flows, compared with past crises, emerging markets have not seen a large influx of hot money in recent years; from the perspective of foreign exchange adequacy ratios, most The ratio of short-term debt/foreign reserves in emerging markets is low, and the ratio of debt to GDP is also significantly lower than in the previous crisis; from the perspective of current account performance, the current commodity prices are still rising due to the geopolitical situation, which is beneficial to the international balance of resource countries. Revenue and expenditure improved.

However, there are still several risks that need to be noted for the future development of emerging markets.

One is the escalation of geopolitical conflicts. The conflict between Russia and Ukraine has not yet ended, and the conflict between Palestine and Israel has made waves again. Geopolitical conflicts may exacerbate crude oil price fluctuations and disrupt the global “deflation” process and “soft landing” expectations.

Second, the Fed has turned “hawk” again. The current market consensus is that the Fed’s interest rate hike cycle is most likely over, but members of the Federal Open Market Committee (FOMC) are still divided on this. Whether the marginal weakening trend of the U.S. labor market can continue is still uncertain.

Third, financial conditions are shrinking at an accelerated pace. Although the overseas interest rate hike cycle is gradually coming to an end, balance sheet reduction is still continuing, real interest rates will remain high, bank credit is in a contraction cycle, and the probability of credit risk events is trending upward.

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