The US dollar enjoys a unique status as the world’s reserve currency. More than half of global trade is settled in dollars, ranging from commodities to agriculture to the services sector. For emerging markets, the strength of the dollar has far-reaching implications.

One of the key reasons for the dollar’s significance stems from the foreign currency reserves held by various sovereign central banks.

The US dollar has surged in recent months, as it often does during times of crisis. (The dollar also enjoys the position as a safe-haven currency).

But when the dollar strengthens, it has ripple effects that can be felt across different sectors of the global economy.

While a stronger dollar benefits US exports of agriculture and commodities, it can raise the purchasing costs from importing countries. Supply and demand dynamics in the commodity and agriculture sector are tricky, to say the least.

At a time when the global economy is already weak, and with monetary policy stretched to the seams, it is now more important than ever to understand what the implications are, and the measures being taken to avert another currency crisis in emerging markets.

Emerging markets’ foreign exchange reserves and the US dollar

Foreign currency reserves are very important for non-US economies.

Typically, these central banks use foreign currency reserves to pay for imports and exports in dollars: from crude oil to grains to electronics and vehicles.

FX reserves also serves the purpose of maintaining liquidity in the event of economic crisis. It can impact the exchange rate and cause inflation as a result.

The global economy was already in a precarious position at the start of the year, mainly due to the US-China trade wars. The Coronavirus shock dramatically exacerbated the situation in a matter of a few months.

As a result of this shock, many emerging market economies have depleted their FX reserves at the fastest pace since 2008. According to this report from WSJ, twelve of the biggest emerging markets saw their combined FX reserves falling by $143.5 billion in March alone.

Emerging Market Economies FX Reserves, March 2020 (Source: Arkera)
Emerging Market Economies FX Reserves, March 2020 (Source: Arkera)

When forex reserves start to deplete, it impacts the domestic currency negatively.

The Turkish lira is one such example in recent times. According to the Turkish central bank, the nation’s net forex reserves dropped over half to $25.9 billion in just three months. Experts now estimate that the nation may run out of FX reserves by July at the current pace.

USD/TRY Exchange Rate
USD/TRY Exchange Rate

And this is reflected in the exchange rate for the Turkish lira as seen above. When a currency such as the lira strengthens, it diminishes the competitiveness of exports while making imports expensive, making a dent in the trade balance.

Mitigating the risks of a rising US dollar

Generally, a stronger currency is good for its economy, but this is not the case with the US dollar.

Take the farming sector for example. A stronger dollar reduces the cost of importing machinery and fertilizers from overseas. But eventually, a strong dollar can make exports less competitive.

According to JP Morgan, global USD liabilities stands at close to $12 trillion. This means that the dollar is in huge demand right now. Consequently, the funding costs also rise dramatically due to supply and demand dynamics.

When funding costs rise, it also makes the cost of importing goods and services from the US more expensive.

Trade Weighted US dollar index
Trade Weighted US dollar index

No one, not even the Federal Reserve likes the USD to appreciate rapidly (or depreciate for that matter), as it can have negative consequences directly on the US economy.

Since the start of the Covid-19 crisis, the Federal Reserve stepped in to soothe the global markets. A range of measures undertaken included opening of currency swap lines (a mechanism to maintain easy access to dollars for foreign central banks) and cutting interest rates to near zero.

These measures have managed to prevent the dollar from strengthening further.

The dollar strengthened close to 2017 highs in March this year but has settled somewhat lower, ever since.

Can emerging markets cope with the strength of the dollar?

Thankfully, there is always a silver lining.

When a currency depreciates against the US dollar, foreign investors often jump in to maintain the equilibrium. This comes on the back of the search for higher yields. As currencies decline in value, they tend to become attractive for investors via higher interest rates, all else being equal.

This is already evident, as the report from JP Morgan forecasts on Q2 2020 has to show.

The report suggests that the base case scenario is for a 5.5% return from emerging markets sovereign debt.

This makes sense as the Fed has become the biggest buyer of government debt, suppressing yields domestically. As a result, investors tend to look for higher yielding debt instruments overseas.

Favorable exchange rates can also make equity investments in emerging markets an attractive proposition, as investors can enter markets at a discount. A strong dollar can reduce the cost of acquiring assets in emerging markets, but in certain sectors, the value of the underlying asset may be less affected by currency fluctuations

It is a bit too early to ring the bell, but what is evident is the fact that governments, especially in the emerging market sector, have grown a bit wiser. There is a growing consensus, worldwide, the that focus needs to be on encouraging growth rather than satisfying budget or debt constraints.

While the volatility in the US dollar did cause a turbulence for a short period of time, it is creating new opportunities for investors that will eventually help support emerging market economies.

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