Emerging economies hike rates to defend currencies

FIRST, IT was the central bank of India. A day later, on Wednesday, its counterparts in Turkey and South Africa followed suit in raising interest rates.

But any hopes they had in seeing their currencies stabilise appear to have been dashed, if the disappointing market reaction is anything to go by.

“The fact that currencies have continued to weaken even in countries that have started to raise interest rates opens up a new, and potentially more worrying, phase of the recent turmoil in emerging markets in which beleaguered policymakers find themselves unable to defend their currencies,” said Neal Shearing, emerging markets economist at Capital Economics.

Currencies in emerging economies have been battered in recent days and weeks by a number of factors, including concern over global growth and the US Federal Reserve’s decision to rein in its money-creating stimulus.

A lower currency has the potential to stoke inflation by raising import prices – controlling inflation is the primary responsibility of central banks around the world.

India’s central bank got the ball rolling with its surprise decision Tuesday to raise its main interest rate by a quarter of a percentage point to eight per cent. Though it justified the move in terms of keeping a lid on inflation pressures, protecting the rupee is widely considered to have been a key motive.

Raising interest rates tends to strengthen a currency because it attracts investors in search of higher returns.

Those considerations were clearly behind the decisions in Turkey and South Africa. The Central Bank of Turkey said it was raising its main overnight lending rate to 12 per cent from 7.75 per cent and more than doubling its one-week rate to 10 per cent from 4.5 per cent.

TURKEY’S PLIGHT

The bigger-than-expected increases come after the Turkish lira hit a record low against the dollar on concerns over growth, a police bribery scandal which might destabilise the government, and the change in the Fed’s monetary policy.

Turkey, like other emerging economies, has seen an influx of foreign investment over the past few years as the Fed and other central banks have primed the pump to shore up their economies. Now that the Fed has begun reducing its stimulus, much of that money is expected to be withdrawn.

South Africa’s central bank was clear that the

falling rand had a key role in its decision to raise its main interest rate by a half percentage point to 5.50 per cent despite concerns over growth.

Other developing countries such as Brazil, Chile, Hungary, Indonesia and Thailand may be next to respond to their currency drops.

But will the strategy work in a world of fast- moving financial flows and a growing aversion to risk in the markets?

Some analysts are sceptical that higher interest rates will be enough to stem the volatility and avoid a destabilising inflation trap. Recent experience, they say, is not encouraging.

“The history of using interest rates to defend a currency usually ends in tears,” said Neil MacKinnon, global macro strategist at VTB Capital.

MacKinnon pointed to the experience of Europe before the launch of the euro in 1999. Many currencies had been pegged to each other in the so- called Exchange Rate Mechanism and when markets became volatile in the early 1990s, central banks raised their interest rates to support their currencies.

However, that came at a cost, most notably in Britain. The government there left the currency pact after the Bank of England splashed out billions of pounds and raised its main interest rate a massive five per cent in one day in a last-ditch – and ultimately futile – effort to defeat the speculators.

If one day’s reaction in the markets is anything to go by, it will take some time before it becomes clear whether the rate increases are working.

Despite an early lift, the Turkish lira was struggling again, trading 2.9 per cent lower on the day against the dollar at 2.2444 lira. The South African rand was down 2.7 per cent at US$0.0893.