In the past year, the US dollar has gained 20% in trade-weighted terms (against a basket of trading partners’ currencies). “Moves of this magnitude usually catch someone out,” says The Economist. This time it’s likely to be emerging markets. “Loose US monetary policy… has been exported to emerging markets” in recent years, says Longview Economics.
A weak dollar and low interest rates sent global investors into riskier assets, such as emerging markets, seeking higher returns. But a stronger dollar, and the higher rates that go with it now that the US Federal Reserve plans to tighten monetary policy, means money will head back to America.
A day of reckoning
That always happens when the liquidity cycle turns. But there is a more significant problem: a dollar debt binge outside the US. Non-financial borrowers outside America have racked up $9trn of debt, says the Bank for International Settlements, from $6trn in 2009 and $2trn in 2000. Emerging markets’ borrowings make up half that total, from a third before the global crisis.
It’s mainly down to Asian and Latin American companies, says Ambrose Evans-Pritchard in The Daily Telegraph. They borrowed in dollars at real rates of around 1% – far lower than debt denominated in these firms’ domestic currencies. But this has stored up “a reckoning for the day when the US monetary cycle should turn”. It duly has.
Dollar borrowers face two problems as the currency and American interest rates go up. The rising dollar makes the debt more expensive to service in terms of the local currency. Meanwhile, the interest rate payable on the debt also rises. “Borrowing in dollars,” India’s central bank governor Raghuram Rajan warned recently, “is like playing Russian roulette.”
Who is vulnerable?
In some cases, dollar debt is offset by dollar earnings. Asia as a whole looks fine, says Morgan Stanley. Its companies owe $2.1trn in foreign-currency debt overall. But while 22% of the debt is dollar-denominated, so are a fifth of earnings. China is another story, however.
A quarter of company debt is in dollars, but only 9% of profits are, and 5% of firms hold half the debt. Property firms are especially vulnerable. That suggests a further squeeze on Chinese growth, which will hit the rest of the region. And the yuan’s peg against the dollar “isn’t guaranteed to hold”, says The Economist. So the pain could be made worse by a falling yuan.
These countries can’t count on export earnings offsetting higher dollar costs – many emerging-market exporters trade not only with America, but also with other countries. Also, “whole economies, rather than just the corporate sector, look short of dollars”.
Russia and Brazil have had to bail out firms desperately needing the US currency. This has in turn made their own currencies slide. Some nations are in worse shape: they lack the foreign-exchange reserves to prop up troubled firms, and have short-term government debts “that will gobble up dollars”.
We won’t necessarily see a wave of bankruptcies in emerging markets that hurt banks and pension funds in the developed world. But more expensive US money looks set to squeeze emerging-market production, employment and growth, and not just in areas directly affected by dollar debt.
Nervous investors could demand higher interest rates on all debt to compensate for rising risk. Foreign investors own most local-currency emerging-market debt, says Morgan Stanley. The turn of the interest-rate cycle would tend to encourage them to demand higher yields, implying lower prices. A few years after the commodities slump, emerging markets face another headwind.