After having a great 2017, emerging markets are diving this year.
The MSCI emerging markets index has dropped over 10% since the start of the year, as you can see in the graph below.
Source: Yahoo Finance
The problem is that some emerging markets are struggling to stop their currency from falling against the rising US dollar.
Argentina, Brazil, South Africa, Turkey, Indonesia…they are all seeing their currencies depreciate, and some are also facing political and social unrest.
With falling currencies and an appreciating US dollar, these countries are facing higher interest rate payments on their foreign debt.
You see, to cover any funding shortfalls, governments need to borrow money. Countries can choose to borrow money in their own currency or foreign currency.
Borrowing in their own currency is less risky, as the government can pay off the debt by starting up the printing presses. Yet it is often easier to raise money in a foreign currency, in particular US dollars, as it is more stable.
But doing this can run you into trouble.
Well, because the government doesn’t control the printing presses in US dollars, so they need to use their foreign reserves to pay the debt. That’s why if their foreign reserves fall too low and there are concerns that they could default on their debt they risk a crisis.
The Turkish lira is down by about 42% this year.
The Argentinean peso has lost around 50% of its value. To stop people from fleeing the peso and buying US dollars, Argentina has increased the country’s interest rates to 60%. Yep, you heard right, 60%.
Is the peso’s freefall contained at 60% interest rates? Well, for now…
The thing is, if you know anything about Argentina you know that once there is a loss of confidence, it is hard to restore it, no matter how many photos with smiley politicians you see in the media.
There are fears of contagion. There are concerns that a crisis in Argentina or any other of the emerging countries with struggling currencies could detonate a global crisis.
Meanwhile, as we wrote yesterday, the US economy is chugging along.
Unemployment is low and GDP growth is rising.
Yet all that growth comes with higher interest rates.
A strong US dollar lowers import prices. It also increases American’s real wages by increasing their purchasing power. That is, a stronger dollar makes foreign goods and travelling abroad cheaper.
The thing is, emerging markets are not the only ones struggling with a rising US dollar. In Australia, we are seeing the effects of a strong US currency on the Aussie dollar.
As you can see below, the Australian dollar has been depreciating against the US dollar this year.
The main reason for this is interest rates.
Rising Prices and Debts
The US Federal Reserve kept interest rates at lows after 2008. This has caused asset prices to rise…and debt to increase.
Yet now the Fed is rising interest rates and reducing the size of their balance sheet to normalise their economy, and to have ammunition before the next crisis hits. As you can see in the graph below, the Fed has been lifting interest rates slowly in the last couple of years to reach 2%.
Source: Trading Economics
The European Central Bank is also looking at normalising their economy. They are looking at ending quantitative easing by the end of the year and starting to increase interest rates by next year.
In other words, two major world currencies, the euro and the US dollar, are looking at reducing their excesses of recent years by decreasing their balance sheets and increasing interest rates.
Meanwhile, Australia has been keeping interest rates on hold at a low 1.5%. This means that interest rates are now higher in the US than in Australia.
And it doesn’t look like the Reserve Bank of Australia plans to increase rates anytime soon. Household debt is at record highs, and inflation is not picking up.
The fact that the Australian interest rate is looking like it will be staying low for the foreseeable future means that the Australian dollar is looking less attractive, which is pushing the exchange rate down.
The Fed is looking at two more rate hikes this year and another three next year.
More rate hikes and a stronger dollar could mean more risk for struggling countries around the world. And it could also mean a weaker Australian dollar.
Editor, Markets & Money