Surging Dollar Pressures Some Emerging Economies

The strengthening of the dollar amid the US Federal Reserve interest rate hikes has sharpened pressure on some emerging economies as investors steer funds to the United States.

Funds dedicated to emerging economy equity and debt saw withdrawals of $569 million and $253 million during the week of May 23, according to data firm EPFR Global. That is on top of the $1.6 billion and $2.1 billion taken from the same funds during the week ending May 9, AFP reported.

"The primary explanation for these capital outflows comes from the rising dollar," said Eric Viloria, a strategist at Wells Fargo. Higher US interest rates have prompted investors to rethink investments in smaller economies.

"You do not feel the urge to invest in emerging markets when investing in much lower-risk US assets offers you higher returns," said Chris Low, chief economist at FTN Financial.

The trend marks a shift from the period after the financial crisis when low interest rates in the US gave incentive to investors to seek higher yield overseas, especially in emerging economies.

Argentina, Turkey Suffer

The yield on the 10-year US Treasury is back up at around 3% after hitting an all-time low in July 2016 of 1.3%. The biggest losers from the current dynamic have been Argentina and Turkey, according to the Institute of International Finance. Those two countries have lost 22 and 19% of the value of their currencies since the start of April.

These countries have responded by sharply increasing interest rates, a move not without risk to their own economies.

Argentina's central bank lifted the rate of a key lending rate to 40% as it has sought loans from the International Monetary Fund.

Turkey's central bank last Wednesday boosted its lending rate from 13.5% to 16.5% despite a push from President Recep Tayyip Erdogan, who has sought low rates to boost growth.

The sharp fall in the currencies' value has come as Turkey heads to June 24 presidential and parliamentary elections where Erdogan is seeking a new mandate and a thumping parliamentary majority.

"Turkey is burdened by a large current account deficit, foreign currency denominated debt more than three times larger than its foreign exchange reserves, and double-digit inflation," said Low of FTN Financial.

Turkey has "country-specific" challenges that preceded the dollar's rally, said Andres Abadia, senior international economist, PantheonMacro.

Argentina too has suffered from annual inflation of more than 20% and large trade and budget deficits. The country also remembers well the painful crisis that led to a debt default in 2001.

According to a recent note by Oxford Economics, more than half the movement of the Argentine and Turkish currencies is due to elevated risk in those countries.

By contrast, other emerging economies, including Russia, Poland and Malaysia have seen their currencies fall less precipitously against the dollar because their economies are in better shape.

Why Are EMs Suffering?

The easy answer is that money is fickle and opportunistic—it goes where it can get the highest return, flowing out of countries as fast as it flows in, Bloomberg reported.

This latest upheaval started when the US, Japan and Europe kept interest rates close to, or below, zero to help their stagnant economies recover from the 2008 financial crisis. That made returns on stocks and bonds unattractive, and drove investors to developing nations, where the risks were higher but the payoffs more inviting.

Emerging markets, as a result, have enjoyed a rally in stocks, bonds and currencies. But the reverse is now happening as investors react to several signals from the US—faster growth, rising interest rates and a stronger dollar.

All three indicate potentially higher returns on US investments and thus act as a magnet for money. They also undermine the attraction of riskier emerging markets. The turmoil in Turkey has especially rattled investors.

What Caused Asia Crisis?

It started when a real-estate bubble burst in Thailand, which undermined confidence in the economy, causing foreign investors to sell the currency and withdraw from the stock market. The crisis spread to the banks, and then across much of East Asia.

Many of the afflicted economies had strong growth records that masked weaknesses like nonperforming bank loans, heavy foreign borrowing and rising trade deficits.

Because their currencies were pegged to the dollar, South Korea and other nations were forced to spend billions trying to fend off speculators who were selling their currencies. They soon ran out of dollars and had to give up the peg and devalue their currencies. The contagion spread when foreign investors pulled back from other countries in the region seen as having similar problems. Several ended up seeking bailouts from the International Monetary Fund.