Why is the US dollar causing chaos for emerging market currencies?

2024-04-16 20:47:35

Why is the US dollar causing chaos for emerging market currencies?

Total chaos has been affecting the currencies of emerging countries for some time, with the US dollar emerging as a star at their expense in a number of countries. The Taiwan dollar and the Indian rupee fell to multi-year lows this week, and although central banks can slow currency weakness, they rarely prevent it.

Emerging market currencies have tumbled this year as the value of the dollar has risen. Taiwan’s currency fell to its lowest level in nearly eight years this week, the Indian rupee fell to a record low, and the Malaysian ringgit approached its lowest levels since the Asian financial crisis in 1998. Only one of the currencies of 23 countries has risen once morest the dollar this year. A developing country tracked by the US Bloomberg Network Index. So why does the US currency cause this reality?

• What is the secret of the rise of the US dollar this year?

The driving wind behind the dollar has been the “exceptionalism” of the United States. While most of the global economy is seeing only moderate growth, US data from employment to retail sales to inflation have often exceeded analysts’ expectations. This reality prompted traders to reduce their bets on interest rate cuts by a decision by the Federal Reserve (the US central bank), which helped boost the dollar’s ​​gains. The Bloomberg Dollar Spot Exchange Rate Index, which tracks the US currency once morest 12 of its major counterparts, has risen more than 4% this year.

• Why are emerging market currencies falling?

The strong rise of the dollar and the possibility of higher US interest rates for a longer period were the most prominent drivers in this regard. The Federal Reserve’s maximum base rate is currently 5.5%, meaning investors are able to get attractive returns from holding dollars without having to bear the exchange rate risk of sending money to emerging markets.

While a number of developing countries offer a productivity advantage over the United States, in many cases this advantage is diminishing. At the beginning of last year, the interest rate in Brazil was 13.75%, compared to 11.25% in Chile, and 13% in Hungary. Since then, central banks in the three economies combined have cut key interest rates by more than 12 percentage points.

• Why were Asian currencies exposed to such remarkable risk?

Asian currencies have suffered the biggest declines this year, mostly because interest rates at central banks in the region are lower than those of most other emerging markets. For example, the key interest rate in Malaysia is 2.5 percentage points lower than that approved by the US central bank. Interest rates in Thailand, South Korea, Taiwan and China are also lower than those in the United States.

While US policymakers have been raising borrowing costs over the past two years, China’s central bank has been easing policy to support Beijing’s faltering economy. This has led to the yuan being subjected to constant pressure, and this reality has seeped into other Asian currencies as well, especially the currencies of South Korea and Taiwan, which enjoy close economic ties with China.

• How do Asian central banks support their currencies?

Rising expectations that US interest rates will remain high have deterred Asian central banks from cutting their own interest rates due to concerns regarding potential currency weakness. Policymakers across the region have also unleashed a number of tools to strengthen their currencies. China used the daily exchange rate to support the yuan, while state-owned banks sought to strengthen the currency by selling dollars.

The Bank of Indonesia has used its foreign exchange reserves to buy the rupiah, while Malaysia’s central bank has encouraged state-linked companies to repatriate foreign investment income and convert it into ringgit. But central banks know they are walking a fine line. If foreign reserves are depleted too quickly, this might fuel concerns regarding their long-term financial stability. Even the Bank of Japan, which has a lot of power to defend the yen, has only intervened to support its currency directly in the market three times in 2022.

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