If inflation accelerates, currency depreciation is likely to increase pressure on domestic prices
Developing countries live their economic lives at the mercy of the US Federal Reserve. That may sound harsh, but it doesn’t make the truth any less.
As monetary conditions ease in the US, capital will flow into emerging markets, making it easier for these countries to fund themselves. But when the Fed tightens monetary policy, as it is doing now, the direction of capital flows reverses as it seeks higher and more reliable yields in the US.
This cycle is commonly understood as the impact of higher or lower US interest rates on capital inflows to developing countries. However, these countries are not only affected by US asset returns; The dollar exchange rate also plays a major role in this drama.
Here are four reasons why a stronger dollar makes life harder for emerging markets.
First, a stronger dollar tends to dampen global trade growth. It is the predominant currency for the accounting and settlement of many global commercial transactions. As the purchasing power of non-US currencies falls as the dollar appreciates, the strength of the US currency is making the world poorer and less traded.
Since developing countries are typically what economists call small, open economies, particularly dependent on world trade, anything that puts pressure on them is likely to be painful for them.
Second, a stronger dollar tends to undermine the creditworthiness of developing countries whose debt is denominated in US currency. The dollar appreciation makes it more expensive for countries to buy the US currency they need to service their debt. This is likely to be most painful for low-income countries, which typically have limited ability to borrow internationally in their own currency, even in the best times.
Third, a strong dollar is likely to be uncomfortable for China these days, and what’s bad for that country is bad for emerging markets in general, given their links to Chinese supply chains and commodity demand.
While, at first glance, it might seem tempting to think that a weakening yuan could be a convenient way to boost Chinese exports, two major forces are working in the opposite direction.
First, by raising the cost of imported goods, a weaker yuan is making life difficult for China’s small and medium-sized enterprises, which are already facing a prolonged decline in profitability. Second, a weakening yuan tends to trigger capital outflows from China, which Beijing authorities prefer to avoid to maintain positive expectations for their currency.
Finally, a stronger dollar should now be more inflationary for emerging markets than in the past. The last few years have made us forget that a devaluation of a currency in an emerging market can quickly lead to inflation. Because the so-called “passage effect” of the exchange rate on inflation has been rather small in recent years.
However, the past cannot be a good guide to the present. One of the main reasons exchange rate depreciation has not led to inflation in recent years is that global inflation has been stubbornly low. But now everything has changed. It is worrying that when inflation is accelerating, currency depreciation is likely to increase pressure on domestic prices. Add fuel to the fire, and you will get more fire.
The world economy is currently a rather hostile environment for developing countries: growing risks of recession in the West; uncomfortable slowdown in China; reduced availability and higher funding costs as investors become less risk-averse; acceleration of inflation almost everywhere; and growing concerns about food availability in several countries.
And that is only in the foreground. In the background, future FDI flows to emerging markets fuel the prospect of de-globalizing efforts by policymakers in the US, Europe, and China to achieve a sustainable supply chain.
All in all, the last thing developing countries need is a stronger dollar. However, the problem may not go away anytime soon. In the early 1980s, when the United States last faced a serious inflation problem, the dollar appreciated nearly 80 percent. History may not repeat itself completely, but if the dollar continues to appreciate with the same ferocity as it did 40 years ago.