Currency market mess & old-school solutions

Currency markets are in turmoil. The US dollar keeps getting stronger; other currencies weaken in response. Interest rate expectations have flipped: cuts are off the table, so much so that chances of hikes by the US Federal Reserve are now being discussed. Meanwhile, US-China tensions continue to simmer. Conflict in West Asia threatens to disrupt shipping routes and oil supplies. With so much uncertainty, it is not surprising that demand for dollars, both for safety and returns, has shot up. But there is more going on than just geopolitics and interest rates.

1 Yield Advantage: US

US YIELDS are now higher than they were at the beginning of 2024, and are expected to stay higher for much longer. Comparable yields of other countries have not risen to the same extent. This places most countries—both advanced and emerging—at a yield disadvantage. A widening yield gap puts pressure on their currencies to weaken. Hence, a wide swathe of developed nations’ currencies have also slumped against the dollar; emerging economies face a double whammy with riskaversion also coming into play.Countries are trying to combat the fall in different ways. India has intervened to support the rupee, Malaysia has urged businesses to repatriate and convert export earnings to boost the ringgit, and Indonesia unexpectedly raised the policy rate to stabilize the rupiah. The Bank of Japan has warned of possible rate hikes, and South Korea issued a joint statement with Japan and the US expressing serious concern over the strong dollar.

2 Oil Price Tail Risk

OIL PRICES have been edgy since the oil producers’ cartel announced production cuts in March. However, it was the sudden direct conflict between Israel and Iran in April that pushed the price of Brent crude above $90 per barrel. Prices have moderated since then, but a rise in oil price remains a tail risk that no country can afford to ignore.

For oil importers such as India, China and South Korea, the impact is direct and obvious. Higher crude prices imply higher import bills and a worsening trade deficit, which weaken the currency. But even oil exporters (Malaysia, US) are affected by second-round effects: rising pump prices reduce household purchasing power and push up prices of goods and sectors in which crude is an input. A return of inflation is a potential nightmare for countries going to polls this year (India, US), or for those struggling to restore growth to prepandemic levels (China, Indonesia).

3 China Exposure

CURRENCIES OF countries with large China exposure are worse off due to China’s uncertain recovery. This group of mainly Asian high-performers had benefited hugely from China’s steady pre-covid growth. Markets are justifiably anxious about their future prospects now. The nature of China-reliance varies: South Korea has invested in semiconductor factories there, Japan recently restricted exports of advanced chip-making equipment to China (yet China makes up about 20% of its exports). Over 70% of the exports decline in Taiwan in 2023 was attributed to a drop in exports to China. In contrast, Brazil, which exports a diverse basket of agricultural necessities and commodities, may be less vulnerable, and Australian firms have already found customers elsewhere. (But both countries’ currencies have also faced pressure.)

4 Fiscal Prudence

COUNTRIES WITH significant amounts of dollar debt are most at risk when the US dollar strengthens, because a weaker currency makes it harder to repay debt commitments. In addition, large populist or non-productive government spending weakens the exchange rate, even if it is funded by domestic debt. That’s because such fiscal expansion diverts government revenues away from productive expenditure. Thus the overall debt score card has an impact on currencies, particularly for emerging markets.Markets prefer fiscal prudence: a weaker fiscal stance and the resulting government borrowing pushes the currency down. For instance, the Brazilian real dropped sharply in April when the government proposed new rules to loosen budget deficit targets. In Indonesia, when the incoming government announced a free school lunch scheme that would increase borrowings, it led to huge foreign outflows in the bond market that pushed the rupiah to a four-year low.

5 Economic Growth

MARKETS LIKE economic growth, especially if it’s strong, steady and sustainable. High-growth economies attract foreign capital. For capital-scarce emerging economies, these inflows fund investments and projects that generate jobs and incomes, further enhancing growth and attracting more capital flows. The downside is that dollar inflows put pressure on the currency to appreciate. Recollect how the Indian rupee gained almost each year during 2003 to 2007, riding on five years of boom: we have neither seen such growth nor such appreciation since then. The reverse is true, too: currencies of economies with uncertain growth outlook tend to depreciate. For example, China has continually weakened its yuan recently under pressure from a stronger dollar and weak growth. The lesson is that economies seeking exchange rate stability should focus on growing at a steady clip. Growth is a panacea for most emerging market ills.