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How a Strong U.S. Dollar Can Hurt Emerging Markets

How Can a Strong U.S. Dollar Hurt Emerging Nations?

After years of keeping interest rates near zero, the U.S. Federal Reserve Bank raised its key interest rates by 25 basis points in March 2022 and by another 50 points in May. And, it signaled that it planned to raise rates several more times in 2022 alone as it struggles to control inflation in the U.S.

For American consumers, that means paying higher interest rates to buy a house or finance a car. For American businesses, it means a reduced incentive to expand, because the financing costs will be higher.

It also means a stronger U.S. dollar and greater interest in dollar-denominated investments in general. The value of the dollar hit a 20-year high in anticipation of more hikes.

But what does it mean for emerging markets?

Key Takeaways

  • A strong U.S. dollar generally harms the economies of emerging nations.
  • Emerging markets are reliant on foreign investment and foreign capital, both of which can evaporate when the dollar gains in value.
  • At the same time, higher interest rates make it harder for emerging-market nations and companies to pay their dollar-denominated debts.
  • The worst-case scenario is a greater risk of default.
  • A weak U.S. dollar creates an incentive for companies to invest in emerging markets.

Understanding How a Strong U.S. Dollar Can Hurt Emerging Nations

There are two primary concerns about higher interest rates and a stronger dollar on emerging markets:

  • Capital outflows will reverse as money invested overseas returns to the safer confines of the U.S.
  • Higher interest rates will make it more expensive for overseas borrowers, both businesses and governments, to obtain financing and pay down their existing debts.

Christine Lagarde, the managing director of the International Monetary Fund (IMF), has warned of the “spillover” effect of Fed interest rate hikes is likely to have on volatility in financial markets, especially those in emerging markets.

Bad Timing

The interest rate hikes come at a particularly bad time for emerging market nations. Many are heavily dependent on tourism, which virtually evaporated for two years during the COVID-19 pandemic.

The U.S. dollar was already on an upward trajectory, having risen 8% in one year to a two-decade high as of the end of April 2022.

The COVID Effect

By mid-2020, sovereign debt defaults by emerging markets had reached 7.8%, a level not seen since 2001, according to an analysis by Neuberger Berman, an investment research firm.

Only infusions of cash from the International Monetary Fund, the World Bank, and “Chinese entities” relieved the crisis in some nations, including Kenya, Ivory Coast, Angola, and Ghana.

Capital Outflows

Most emerging markets are heavily reliant on the flow of foreign investment cash from the U.S. and other developed nations. The money helps their businesses and their economies grow. The cash helps them fund their fiscal or current account deficits.

But there are two important facts about capital inflows to emerging markets that must be kept in mind, according to the policy analysis site VoxEU: They are fickle, and they reverse course just when they are most needed by those nations.

As investment returns rise in the U.S., international capital flows away from emerging markets could accelerate and make funding the “twin deficits” more difficult.

The point of the interest rate increases is to relieve inflation in the U.S., but its side effect is to worsen inflation in other nations, not just emerging-market nations.

The COVID-19 shock to the international financial markets caused the transfer of $100 billion from emerging market portfolio investments in just one month.

The Debt Burden

The second downside of higher U.S. interest rates on emerging nations is the increasing cost of U.S. dollar-denominated debt.

Emerging-market governments, corporations. and banks took advantage of low-cost borrowing to shore up their finances.

This is doubly problematic because local currency devaluation caused by a reversal of capital flows can make servicing this dollar debt more difficult. Corporations and banks that borrowed in dollars could be facing greater pressure if they don’t have matching increases in revenues.

Estimates of exactly which countries are most exposed vary widely and change frequently.

As of 2021, the list of countries most vulnerable to Fed rate increases due to their high levels of foreign-denominated debt was topped by Hungary, Peru, Turkey, and Poland, according to the Federal Reserve.

When to Expect Rate Hikes

The Federal Reserve Open Market Committee announced an immediate increase to 0.9%, effective May 5, 2022, in the short-term interest rates it charges banks. In its press release, the Fed said it “anticipates that ongoing increases in the target range will be appropriate.” Its overriding goal is to reduce inflation in the U.S. to 2% and keep it there.

The half-point hike was the largest increase in 22 years. And, Fed Chairman Jerome Powell said equal increases will be considered at future meetings throughout 2022.

The issue, in the U.S., is the impact of rising prices on consumers buying everything from gasoline to groceries. The Fed blames a combination of unusual factors, including the Russian invasion of Ukraine and the COVID-19-related lockdowns in China.

Is a Strong or Weak Dollar Better for Emerging Markets?

Generally, a weak U.S. dollar is good for everybody but Americans. When the value of the dollar drops, American exports are cheaper for foreign consumers. Foreign cash flows in, in search of better returns than are available in the U.S. Interest rates remain low, making debt easier to pay off.

How Does a Strong Dollar Affect Emerging Markets?

When U.S. interest rates increase and the U.S. dollar grows stronger, emerging market nations feel pressured to raise their own rates in order to continue to compete for foreign capital investment.

That move may slow some of the outflows of foreign money, but it also risks slowing their economies. Meanwhile, the interest rate increases make their sovereign debts harder to pay off.

Why Is a Weak Dollar Good for Emerging Market Funds?

Historically, a weak U.S. dollar is good for the economies of emerging-market nations and for the stocks of their companies.

For example, the U.S. Dollar Index (DXY) was relatively weak throughout 2020, declining 10% from February through December of that year. During that time. emerging markets equities returned 19% overall.

When it comes to emerging market fund performance, diversity rules. Diversified mutual funds may invest in the stocks of companies that thrive in weak-dollar times as well as those that sink when the dollar is weak. Companies that export commodities do well when the dollar is strong.

The Bottom Line

Rising U.S. rates are likely to present specific challenges to emerging markets, especially those with external financing vulnerabilities such as Brazil, Turkey, and South Africa.

Emerging-market governments, companies, and banks that have large amounts of dollar-denominated debt will find them becoming increasingly expensive to pay off.

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