A definite pattern emerges when looking back at the history of the US Dollar and emerging market asset performance. When the USD has gained strength over a prolonged period, assets (both equities and bonds) have started to lag. The opposite is true as well. Emerging market asset performance improves with a weaker US Dollar. There are several reasons for this correlation, and understanding these underlying market forces can help investors position themselves ahead of rate hikes, monetary policy changes, and other catalytic events.
What are the factors that cause the US Dollar to fluctuate?
Before we explore the impacts of the US Dollar on emerging market economies, it is worthwhile to understand the primary drivers of a strong or weak USD. While there are a lot of forces at play in the foreign exchange markets, there are some key variables that can materially impact the USD. Some are listed as below:
Increase (decrease) in total money supply
Increasing the total value of notes and coins in circulation within an economy can cause a currency depreciation, and vice versa with a reduction of the total money supply.
An increase in the number of dollars it takes to purchase an item reduces the value of the dollar itself.
Low interest rates can lead to an increase in inflation as more people and companies can afford to borrow debt cheaply to fund expenditures. As we have seen above, inflation reduces the value of the dollar. The opposite is true as well. As interest rates edge higher, the dollar is more likely to appreciate as inflation gradually comes back under control.
Confidence in the US economy correlates to a greater amount of inbound investment which drives asset prices higher.
What happens to emerging markets when the US Dollar appreciates?
At a fundamental level, there are three main reasons why emerging market assets tend to underperform with a rising US Dollar.
Higher Costs of Borrowing
During times of low interest rates defined by the US Federal Reserve, governments and enterprises in emerging markets seek to capitalize on a weaker US Dollar to finance growth projects. Governments may borrow capital denominated in USD to fund infrastructure or other social welfare programs, while corporates might expand their balance sheets to pursue growth capital expenditures. These projects fuel economic growth, productivity, and output when the US Dollar is in a position of relative weakness. However, as the tide turns and the USD currency strengthens against the local currency of the emerging market, repaying the debt borrowed becomes more expensive.
This is due to the higher interest costs now incurred on the debt denominated in US Dollars. Given that interest is an operating expense recorded on company P&L statements, higher borrowing costs will reduce net earnings and margin, all else being equal. As corporate earnings decline, the valuations of their corresponding equity and bonds also follow. Ultimately, this results in underperformance of asset prices at a broader market level. To illustrate the concept, consider the example below.
Company A, based out of an emerging market country, borrowed debt denominated in US Dollars for a total sum of $1 million. At the time that the borrowing decision was made, the USD traded at a rate of 1:50 where US$1 could buy 50 of the equivalent local currency. Assuming that the debt had a 8% coupon paid annually, investors were paid back US$80,000 every year. This translated into 4 million of the local currency (converted at US$1 to 50 of the local currency).
A year later, the US Dollar has now appreciated such that US$1 can now buy 60 of the equivalent local currency. Assuming the same coupon rate as before, investors are still paid back US$80,000 every year. However, for the company that generates their revenues in local currency, the stronger US Dollar means that they spend a local currency equivalent of 4.8 million in annual interest costs (compared to 4 million previously). As such, their corporate earnings in the second year are lower by 800,000 compared to the first. Lower earnings then get reflected in the valuations that the company commands on the market accordingly.
Countries in developing economies tend to have a greater reliance on inbound capital flows that can fund the deficits they incur in their current or fiscal accounts. In the event that interest rates are pushed higher by the Federal Reserve in the US, yields on assets like American stocks and bonds would rise as well. At that point, investors would start to re-allocate their capital away from emerging market economies towards US assets to earn the higher returns on offer. As the supply of capital diminishes, asset performance in emerging markets tends to decline as well.
In such a scenario where investors divert capital away from emerging markets, countries with low foreign exchange reserves (measured as a percentage of external debt) and high current account deficits (measured as a percentage of GDP) are most vulnerable.
An appreciating US dollar can be unfavorable for emerging markets reliant on the export of a commodity. This is because most major commodities are priced in the US Dollar. As a result, exporters of commodities based out of emerging markets lose value in real terms if their currency depreciates against the US Dollar.
The US Dollar is a crucial consideration for investors with existing assets in emerging markets and prospective emerging market investors. In times of the dollar’s appreciation, different emerging markets are impacted differently based on their economic strength and the composition of their exports. As investors, it is wise to establish a long-term view of the US Dollar’s movements to allocate and grow capital effectively.
Given the recent pivot of the Federal Reserve to monetary tightening via interest rate increases and the multi-decade high inflation rates leading to higher treasury rates at the short- and long-end of the curve, we may start to see a shift to higher USD soon. You will want to pay close attention if you’re in emerging markets.