Many economists and commentators have recently urged the US Federal Reserve Bank to stop hiking Interest Rates, which reached a 22-year high in July 2023. This argument is supported by the fact that more tightening in the monetary policy shall drive the sluggish global economic growth rates to a worse slowdown. In addition to this, they claim that the US monetary policy has made a good “soft-landing,” contradicting most of the early 2023 forecasts.

The expression of “soft landing” is well earned, certainly, because the US inflation rates are now restored near the 2% target (at 3.3% in July 2023), down from more than a 40-year record of 9.1% hit in June 2022. Meanwhile, this containment of inflation rates came with a modest bill; as the real GDP has grown by 2.4% (annualized) in the second quarter of 2023, well above the forecast of 1.8%, and way better than the real GDP growth in the second quarter of 2022, that scored a negative rate of 0.9%.

Concerns of De-dollarization

However, the US Fed's agenda might be completely distorted by the newly increased calls for de-dollarization, which erupted in response to US sanctions against Russia. In summary, the Fed is eager to rapidly restore positive real yields on US treasury bills and bonds to counteract any substantial movements against the US dollar's dominance.

The BRICS 15th summit, held this month in South Africa, highlights the group's determination to counter G7 economic and financial supremacy, as well as dollar domination. Emerging economies might then play a more prominent role in the new global financial system.

Emerging Markets at a Glance

The sphere of emerging markets (EM) is complex and challenges a single narrative. Although no formal definition exists, emerging markets are often classified based on characteristics such as sustainable market access, advancement toward middle-income levels, and increased global economic importance. Nonetheless, these economies are unique, and the boundary between emerging markets and other developing economies is unclear.

According to the IMF World Economic Outlook, “39 economies are classified as "advanced," based on variables such as high per capita income, diverse exports of goods and services, and deeper integration into the global financial system.” The others are categorized as "emerging market and developing economies." Based on their greater revenues, 40 of them are classified as "emerging market and middle-income" nations by the IMF Fiscal Monitor.

Tightening Monetary Policies

Spillovers from US shocks, global risk appetite, interest rate impacts, and distinctive domestic shocks are the key drivers of emerging country exchange rate movements.

According to the IMF, following the outbreak of the pandemic, household savings grew in the majority of emerging economies. Domestic savings were used to fund governments, minimizing the need for foreign borrowing, which, along with lower private investment, kept external deficits under control. These deficits are the main structural reason behind currency devaluations.

Emerging-market currencies have been driven into a race against a stronger dollar and inflationary waves induced by the European conflict and the demand restoration following COVID-19 lockdowns. Whether pegged to the US dollar or not, central banks throughout the world are attempting to keep their currencies on track by keeping up with the US interest rate rises, which are presently running between 5.25% and 5.5%, up from near zero levels last year.

In addition, accumulating greater foreign reserves is a common defense technique against a higher US currency. These reserves serve as a buffer against capital outflows and hot money's desire for less risky, yet higher-yielding, dollar-denominated debt instruments (such as treasury bills and bonds). This technique tends to strengthen the dollar even more.

The consequences of the strong dollar extend through trade and financial networks in emerging economies. “Their real trade volumes fall more swiftly, with imports falling twice as much as exports,” as stated by Rudolfs Bems and Racha Moussa in their IMF blog. Emerging market countries also suffer disproportionately in terms of credit availability, capital outflows, the impact of tighter monetary policy, and larger stock market falls.

Best Performing Currencies

The share of worldwide aggregate foreign currency turnover, including emerging market currencies increased from less than 2% in 1995 to more than 25% in 2019, in an article titled “Directional predictability in foreign exchange rates (ER) of emerging markets: New evidence using a cross-quantilogram approach,” published in Borsa Istanbul Review.` As a result, emerging markets currencies have been traded more aggressively, with a greater proportion of transactions occurring overseas and in the form of derivatives (options and future contracts).

While typical commodity exporting emerging and developing economies enjoyed better terms of trade, with the relatively stronger dollar, pressure on ER seemed to be less severe on these countries than on advanced economies. Brazil and Mexico, have even appreciated ER against main currencies.

Among the strongest currencies in the year 2023, Forbes has listed Kuwaiti and Bahraini dinars, followed by the Omani rial and the Jordanian dinar in the first four places of this list. They are all developing nations, and their currencies are pegged to the USD with fixed rates (except for the Kuwaiti dinar is pegged to an undisclosed basket of currencies).

Armenian, Albanian, Georgian, and Mexican currencies are considered the best performers between 2020 and June 2023.  They managed to appreciate against USD in a range of 24% and 9%, as per FDi Intelligence.

In the last six months, Colombian and Mexican pesos, followed by Brazilian real and Polish zloty, performed best among the emerging markets currencies in terms of total net carry trades (borrow relatively cheap and re-invest in a higher return vehicle).

Worst Performing Currencies

The Iranian rial is the world's cheapest currency in 2023, followed by the Vietnamese dong and the Sierra Leonean Leone. Other currencies that have performed poorly this year include the Venezuelan bolivar, the Lebanese lira, the Argentine peso, and the Turkish lira. They all lost between 100% and 75% of their value between 2020 and June 2023. If we include parallel market exchange rates, the Egyptian pound and the Lebanese lira are of the top worst performers, but it is still the seventh worst-performing currency over the same time period if just official exchange rates are used.

Aside from the fact that a relatively weak currency makes domestic consumers poorer, it can also cause tensions with a country's trading partners. A government that deliberately maintains its currency weak, gets an unfair competitive advantage over others, and its partners criticize its exchange rate for being purposefully undervalued. This has always been the main reason behind the US/China's complicated monetary relationship.

On the other hand, when fundamental vulnerabilities in the national economy cause currency depreciation, no one can predict the lowest point this currency may hit. Consequently, inflation will keep punishing all the residents until the balance is restored. In most cases, such required balance comes with a high political and social invoice.

Despite sluggish domestic growth and China's weaker economic performance, many emerging market currencies have remained resilient, thanks mainly to rate differentials that allowed investors to engage in carry trades.

Easing on “Bull Markets”

A recent Reuters poll indicated that most “emerging market currencies will hold on to gains into next year, provided their respective central banks maintain or only moderately prune already-high interest rates that have boosted carry trades.”

Most of the currencies surveyed, including the Thai baht, Indian rupee, and South African rand, were expected to preserve current gains by the end of the year. Latin American currencies are also expected to remain reasonably robust in the following months, as the Brazilian real is supported by improved economic prospects and fiscal reforms, while Mexico's peso benefits from foreign capital inflows shifting from China. Despite its central bank cutting rates just a few weeks ago, the Chinese yuan will likely appreciate 3.5% to 7/USD in six months.

Emerging markets currencies have the potential to continue to provide good overall returns. With developed economies on a slow but non-recessionary growth path and gradual deflation, major central banks are nearing the end of their monetary policy tightening cycle, so any rate normalization in the emerging economies is likely to be prudent in the face of rising rates in big developed economies, preserving a still generous interest rate differential.

Furthermore, within EM, the large cuts already factored into market expectations in the near term suggest that, even as rates begin to normalize, central banks should be able to surprise markets on the hawkish side. Finally, with inflation falling in most EM states, rising interest rates should eventually come to an end.

Financial Markets and ER risks

Domestic financial market growth can help support and promote flexible exchange rate regimes by reducing the vulnerability of domestic borrowing conditions to the exchange rate. Long-term commitments to improve fiscal and monetary frameworks serve to underpin inflation expectations. This involves ensuring a well-balanced combination of fiscal and monetary policies, increasing central bank independence, and continuing to improve communication effectiveness.

Macroprudential and capital flow control policies for emerging market economies with high financial frictions and balance-sheet vulnerabilities might assist in preventing negative cross-border spillovers.

In terms of emerging market currency stability, policymakers and financial regulators can benefit from a better knowledge of net recipients and net transmitters of currency movements by analyzing the co-movements of their home currencies and other emerging market currencies. The capacity to identify net recipients from net transmitters of foreign exchange movements in these countries at different stages might help policymakers and regulators to design a surveillance system for modifying market interdependence effects, as stated in Borsa Istanbul Review. 

References

• Bems, Rudolfs, and Racha Moussa. “Emerging Market Economies Bear the Brunt of a Stronger Dollar.” IMF, 19 July 2023, www.imf.org/en/Blogs/Articles/2023/07/19/emerging-market-economies-bear-the-brunt-of-a-stronger-dollar.
• Duttagupta, Rupa, and Ceyla Pazarbasioglu. “Miles to Go: The Future of Emerging Markets – IMF F&D.” IMF, IMF, www.imf.org/external/pubs/ft/fandd/2021/06/the-future-of-emerging-markets-duttagupta-and-pazarbasioglu.htm. Accessed 4 Sept. 2023.
• Frieden, Jeffry A. Currency Politics, 2014, https://doi.org/10.2307/j.ctt9qh0gz.
• Rehman, Mohd Ziaur, et al. “Directional predictability in foreign exchange rates of emerging markets: New evidence using a cross-quantilogram approach.” Borsa Istanbul Review, vol. 22, no. 1, 2022, pp. 145–155, https://doi.org/10.1016/j.bir.2021.03.003.