How does the change in the value of the US dollar affect emerging markets?

Author : rui wu | Published On : 22 May 2023

As we all know, the change of the Fed’s policy stance often represents a cyclical change in the strength and weakness of the US dollar, and starts or terminates the feedback loop between emerging markets and the US dollar, which is dominated by US dollar financing. This feedback loop passes through cross-border credit, capital flows, commodities These four ways link emerging markets to the dollar. We refer to the relevant reports of BIS and Goldman Sachs to sort out and explain how the strength of the US dollar affects emerging market countries.

Cross-Border Credit

Companies in emerging markets invest by borrowing dollars in international markets and converting them into local currencies through central banks. This behavior accounts for the vast majority of cross-border lending and international debt. At present, US dollar credit accounts for 70% of cross-border foreign currency credit, and these credits are mainly obtained by companies and banking sectors in emerging market countries.

Based on this situation, we do path deduction:
the Federal Reserve’s monetary policy stance is more accommodative than other central banks.
The dollar weakened against other currencies.
A weaker dollar puts borrowers in emerging market countries in better balance sheets as their liabilities are denominated in value.
A healthy balance sheet provides incentives for borrowers in emerging market countries to further borrow and increase leverage.
The borrowed U.S. dollars need to be converted into local currency, which pushes up the ratio of the local currency, and the reinvestment behavior increases the price of local assets, so that the asset side appreciates again.

flow Strictly speaking, capital flow has similar concepts with cross-border credit, but it is also very different. When the Fed’s stance is dovish, the US dollar as a funding currency will inspire investors to engage in highly leveraged carry trades.
Based on this situation, we make a corresponding path deduction:
the Federal Reserve’s monetary policy stance is more relaxed than other central banks.
The dollar weakened against other currencies.
Investors obtain income by borrowing short-term U.S. dollars in the money market and buying high-yield bonds or stocks of emerging market countries.
Investors get income from two parts, one is the difference between borrowing costs (money market interest rates) and income (bond interest rates and stock dividends), and the other is asset appreciation (asset appreciation).
Expectations of asset appreciation further fueled the carry trade, with more participants borrowing dollars.
Chart: Overseas investors in US stocks

The central bank’s response

The previous two positive feedback loops are likely to stimulate asset bubbles in emerging market countries, so policymakers in emerging market countries are not completely passive in the face of capital inflows. Given the destructive nature of asset bubbles, policymakers often prefer to use domestic monetary policy or foreign exchange market intervention to dampen the cycle. However, the use of local YSHX  yunshfx  Yun Shang Hui Xin Limited monetary policy or intervention in the currency market cannot completely solve this problem. Sometimes it even amplifies the power of positive feedback between the dollar and emerging markets.
Based on this situation, we do path deduction:
the Federal Reserve’s monetary policy stance is more accommodative than other central banks.
The dollar weakened against other currencies.
Emerging market policy makers cut interest rates, hoping currency depreciations would break the positive cycle.
The monetary policy of cutting interest rates reduces local borrowing costs and stimulates borrowing in local currencies.
Excessive credit entering the market pushes up local asset prices, thereby further attracting foreign capital.
Excessive asset price levels lead to inflation, and policy makers have to raise interest rates to tighten liquidity.
The interest rate hikes in emerging markets widened the spread of carry trades, attracting more carry trades and further pushing up asset prices.

Commodity prices typically have a strong negative correlation with the US dollar. Large-scale producers in emerging market countries often use the US dollar as the main financing currency to support their daily operations.
When the dollar weakens and commodities appreciate, some commodity-exporting emerging economies have healthier balance sheets—as their assets appreciate and their liabilities fall.
This makes financing cheaper for commodity producers, expanding their dollar liabilities. And this cheap credit feeds into local growth and boosts asset prices.
At this point, the previous cycle repeats itself once again. And when the Fed tightens money, everything starts to reverse, a strong dollar lowers commodity prices and weakens producers’ balance sheets, while lower credit hurts economic growth and lowers asset price levels, all of which Will make money flee emerging markets back to the dollar and make the dollar stronger. This cycle mainly occurs in emerging market countries such as Brazil and Russia, which rely on commodity exports for income. For many emerging market countries that need to import large quantities of commodities, lower commodity prices benefit them.

A similar situation will also occur in the previous concentrated situation. When the Fed tightens monetary policy to drive the appreciation of the dollar, whether it is through credit or through the release of carry trades, the withdrawal of funds will not only affect the growth prospects of emerging market countries, It will also cause the price of its assets to fall. And this decline will also have a positive feedback effect: lower growth prospects, deteriorating balance sheet conditions and the prospect of falling asset prices tend to accelerate the withdrawal of funds from emerging markets. And this has happened several times over the past few decades. (Source Wall Street News)