How the dollar is preoccupying emerging economies

National debt is skyrocketing in the growth markets. The pandemic presents them with challenges. Turkey is considered a high risk country.

Corona keeps the emerging country India under control: people are queuing in Mumbai to get a vaccination.

Dhe US Federal Reserve (Fed) should welcome the current weak phase of the dollar. On the one hand, cheaper export prices for American goods support the economy, on the other hand, a cheaper dollar helps the emerging countries particularly affected by the pandemic. If the Fed’s Open Market Committee deliberates on how to proceed this Wednesday, a continuation of the loose monetary policy is likely.

The fund manager of the Scandinavian bank Nordea, who specializes in emerging market equities, Juliana Hansveden, expects the Fed to be aware of a possible feedback of its interest rate decisions in the emerging markets for two reasons. First, the Fed’s policy affects the demand for American products and oil prices. Second, there are strategic reasons to stabilize allies with foreign exchange swap lines. Here foreign central banks receive dollars in exchange for their currency from the Fed, which they can then make available to their commercial banks and thus to the economy.

The corona crisis is weighing on the emerging countries, including economies as diverse as China, Turkey, Russia and Mexico. According to a paper by the Institute of International Finance (IIF), the national debt of emerging countries has risen rapidly in the pandemic. Nonetheless, with a good 60 percent of the annual economic output (gross domestic product; GDP), they are still at a low level compared to the industrialized countries.

High dollar debt

However, the high dollar indebtedness in these fast-growing countries, which primarily affects companies, is a problem as interest rates have risen in America in anticipation of a strong economic recovery with a surge in inflation. Although the yield on ten-year US government bonds is 1.5836 percent, 0.18 percentage points below the high reached at the end of March, it is still almost one percentage point higher than in June 2020.

The current weakness of the dollar is relaxing because the higher interest rate level is not also driving the dollar upwards. According to Nordea specialist Hansveden, dollar centricity has increased outside of the United States, especially in emerging markets. The companies there have become more cautious and in some cases need more dollars than hard currency, she replied to the FAZ. “In some countries like Turkey, one can even speak of dollarization,” she adds. In general, there is an increase in dollar liquidity in emerging countries.

At the same time, however, some countries have tried to reduce their peg to the dollar, both as a means of transaction and as a reserve currency. This applies mainly to Russia, followed by China. The dollar risks are highest in China and also in Mexico. Given the weakness of the Mexican peso, the Nordea fund manager expects a large part of the dollar debt to be swapped into the local currency.

It regards Turkey, which is stuck in an economic and currency crisis, as a high-risk country. The problem here is an excessive focus on generating growth, which leads to high inflation and thus to the dollarization of deposits. The emerging markets are lagging behind in terms of equity market development this year. Since the beginning of the year, the MSCI World share index has increased by almost 10 percent. The emerging market counterpart MSCI Emerging Markets only rose by a good 5 percent.