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The problem in strong dollar and rising US bond yields for emerging market

Rekha Sai Teja 
on 02 June 2018

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WHAT IS THE ISSUE WITH STRONG US DOLLAR AND HIGH BOND YIELDS?

At first, we think if a rising US dollar could be positive for developing Asia. Because a stronger US currency means American consumers have more purchasing power when they go shopping for goods made in Asia’s factories. That means exports should contribute more to the region’s growth.

But the thing is Investment is more important as an engine of Asian growth than net exports. And with US interest rates being at bottom levels over past recent years, many Asian companies have chosen to fund their investments with US dollar debt.

A Rising dollar is exposing weaknesses in the developing world, pushing investors to square off their long-term securities in emerging-market stocks, bonds and currencies. A rise in US bond yields makes local currency bond markets less attractive to international investors and result in low capital inflows into the emerging markets. And if central banks in developing countries raise interest rates to defend their exchange rates against the US dollar, they push up local currency funding costs, restricting domestic investment and thereby slowing growth.

The disturbance of US $ has spread widely. 1) Indonesia’s central bank raised interest rates for the 1st time in 4 years to counter the drop in its currency value.

2) Hong Kong’s monetary authorities last week stepped in to support up the weakening Hong Kong Dollar(HKD).

3) The Turkish lira fell @ 17% till may 23rd to fresh lows against the U.S. dollar, while Brazil’s real (Brazil currency is Brazil Real) declined to its weakest level in more than 2 years. They had to raise the interest rates about 300 basis points i.e., 3% to counter the currency fall.

4)The MSCI Emerging Market Index, which measures stock performance, is down 11%.

Investors have invested in the emerging market stocks and bonds for the last several years.  Now that the dollar is strengthening it makes more difficult for countries to service debt denominated in the U.S. $, and while rising yields diminish the attractiveness of foreign assets.

The markets are now realizing they have to pay attention to fundamentals and assess which countries are the most vulnerable.

Investors are particularly nervous about nations with

1) Large Current Account Deficits and

2) Nations that rely on foreign investment to finance government spending, or fiscal deficits. Their dependence on the rest of the world for trade and government finances leaves them badly exposed when the dollar rises.
✓ Few countries like Argentina, whose currency and stock market plunged in recent weeks amid fears of a having financial crisis, carries both a current account and a fiscal deficit. Other emerging markets with large current-account gaps include Turkey, with a deficit that stood at 5.5% at the end of 2017, as well as Colombia, South Africa, Indonesia, India and Mexico.

Politics are another worry. Mexico’s peso, a top performer last quarter, has been followed by concerns over the renegotiation of the North American Free Trade Agreement and a happening presidential election. The recent climb in oil prices has barely helped the currency of oil-producing Russia, where worries of fresh U.S. sanctions against Moscow have impacted the Ruble.

But if the current parallel trends continue, countries with current account deficits or high levels of debt, much of it owed to foreign investors, will be at more risk. These include Indonesia and Malaysia, and to a lesser extent India and the Philippines.

Indonesia is currently running a current account deficit of around 2% of GDP, with relatively less foreign reserves relative to the size of its economy.

Meanwhile Malaysia’s public debt stands at around 50 % of GDP, with almost half of its local currency debts owed to foreigners, leaving the economy vulnerable to capital outflows.

(At Worse, both countries have responded to higher oil prices with promises of increased fuel subsidies. In Indonesia, President Joko Widodo has reintroduced a subsidy program for first time since 4 years. In Malaysia, Mahathir Mohamad promised to bring in new fuel subsidies in an election campaign and he came to power after elections last week. Already with troubled budget deficits, These Govt. Subsidies will only make it worse and it will further damage sentiment among foreign lenders. There will be a little reliving pressure on household spending power due to subsidies, BUT highly likely to do more economic harm.)

As volatility spreads throughout emerging-market assets, investors who had arrived recently are looking toward the exits.

There is this large amount of new investors who have only experienced the good days. They’ll start leaving. They’re not used to the riskiness.

Jumps in the dollar and U.S. yields have burned emerging-market investors before. Many developing countries borrowed heavily in dollars and kept their currencies tightly pegged to the U.S. currency in the 1990’s. A fast dollar rally forced them to raise interest rates, damaging exports and hurting growth.

Countries including South Africa, Mexico and Brazil have narrowed their current-account deficits.

Still, that may not be enough.

The IMF’s April forecasts, made before the recent turmoil, projected India’s growth at 7.4% and expected both Indonesia and Malaysia to grow by 5.3%.

While Asia’s economies are growing briskly, others are struggling: Argentina is expected to grow at just 2% this year, Mexico at 2.3%, Colombia at 2.7%, Brazil at 2.3%, and South Africa at 1.5%.

A continued rise in the dollar and U.S. yields will punish the healthy emerging markets alongside more vulnerable ones and that’s why there is a significant drop in the MSCI Emerging Markets Index.

The stronger dollar is slowing the flow of loose money floating around the world, looking for something to do with itself.

Now here is the impact of rising oil prices. Asian countries are predominantly oil importers, so a higher US dollar price for oil During the times of strong US dollar gives a higher import bill, and an opposite direction to growth.

# If oil prices are rising primarily because of increased global demand, the negative effects are unlikely to be powerful enough to blow growth off course. But the oil price rise of the last few months is largely due to supply constraints. There could be more supply disruption to come, as Venezuelan production has collapsed and the US administration has sanctions on Iran and those who do business with the oil-producing Islamic republic.

CONCLUSION: The world tends to be a much happier place when the dollar is not going up. ONLY If the US dollar does resume the weakening trend, it will ease the Problems faced by developing economies. If not, Asia should prepare for a Loud Cry.


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