The speech was from Jerome Powell, then a governor at the Federal Reserve and on President Donald Trump’s shortlist to lead the central bank.
Powell was discussing what would happen as the Federal Reserve normalized interest rates. The concern, he outlined in Oct. 2017, was that higher interest rates as well as a weakening emerging-market currencies could cause capital to return to advanced economies. The fact that emerging-market debt is often denominated in dollars and other foreign currencies exacerbates the issue.
That said, Powell looked at the situation and didn’t think it was a big deal. “I have suggested that the most likely outcome is that the challenges posed to [emerging-market economies] by the normalization of global financial conditions will be manageable,” he said. The International Monetary Fund soon came out with a similar report, saying that yes emerging-market inflows will reverse but the process will be “orderly and will not take a toll on emerging markets growth.”
Ten months later, there is some signs that emerging markets aren’t so orderly. Turkey's lira USDTRY, +15.3448% has plummeted 38% this year, including 10% on Friday, as President Recep Tayyip Erdogan has turned to his son-in-law to run a central bank he’s bashed in public repeatedly and has called for his citizens to swap dollars and gold for the domestic currency.
It isn’t just Turkey in turmoil. Argentina in June received a $50 billion International Monetary Fund loan. The Chinese yuan CNYUSD, -0.3055% has weakened by about 7% against the dollar over the last three months, and Brazil’s real USDBRL, +1.2549% has dropped by 15% this year versus the greenback.
Investors have soured, as net inflows have turned into outflows.
Year-to-date, the iShares MSCI Emerging Markets ETF EEM, -2.07% has dropped over 8.5%, compared with a 6% gain for the S&P 500 SPX, -0.52%
Was Powell wrong? Did he not anticipate other factors that would boost the buck, like the corporate repatriation of earnings following tax legislation, or the trade war, mostly aimed at China, that Trump unveiled in the spring?
Phil Torres, global co-head of emerging markets and director of emerging-markets research at Aegon Asset Management, said the story is less about the U.S. dollar and more about specific country situations.
With Argentina, it was a combination of a number of factors—the need to borrow locally, high inflation and a growing and a large current-account deficit—that set the stage for the IMF rescue, with the trigger coming when the U.S. dollar DXY, +0.57% muscled higher and the U.S. stock markets sagged at the beginning of the year. “When risk aversion took hold, people pulled back from Argentina, so that is why they needed the IMF to come in,” Torres said.
Turkey is a different issue. Turkey has been “too aggressive in fiscal spending and that is keeping the economy hotter than it needs to be, and the central bank is not as aggressive in hiking as they should be.” The question now is the degree Turkey will be able to roll over its short-term debt. “We think they are starting from a strong fiscal position. The one thing we are concerned about is the reluctance of the central bank to execute orthodox policy. The rest of it, they are kind of okay.”
China, Torres maintained, isn’t using its currency to combat the U.S. trade clashes. “It does not appear they are using the currency as a trade-war weapon,” he said. “If they wanted to weaken their currency a lot, they could do that.” There is plenty of reasons for China not to want the yuan USDCNY, +0.3064% to weaken too much.
Besides not wanting inflation, China, he pointed out, has been spending the last two or three years battling capital fight after the mini devaluation in 2015. The reason the yuan has weakened is that it was getting strong relative to its Asian competitors in Japan, South Korea, Malaysia and Indonesia. “The adjustment was in large part just making sure they didn’t get overly uncompetitive relative to peers.”
Brazil has its own issues as well. “The currency looked rich, the credit looked quite rich, and there is a lot of uncertainty about their fiscal path, which appears to be getting to a place to concern,” he said. With a presidential election in October, “people have been appropriately paring back risk there.”
If there is one emerging market where the U.S. dollar may have been the trigger for action, it was Hungary, Torres said. “This is probably the one the fits the strong dollar narrative the most. When the dollar got strong, this was the one that really turned without anything else causing it,” he said. But there too, the central bank has been unusually aggressive—using interest-rate swaps for instance to keep borrowing rates low.
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