Foreign exchange weakness: The Achilles’ heel of emerging markets
Foreign exchange weakness
Foreign exchange weakness in emerging markets (VWO) has followed a strengthening U.S. dollar as the start of quantitative easing tapering gets closer. Historically, countries with a weak account deficit suffer in the short term when their currencies depreciate.
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The current account deficit is equal to the sum of:
- Exports minus imports (balance of trade)
- Earnings on foreign investments minus payments to foreign investors
- Cash transfers (remittances and other cash transfers)
While a deficit generally means a country is investing more than it’s saving, faster output growth is observed in the more developed markets, where a deficit is normal given their ability to attract foreign capital. Developing markets (EEM) usually have surpluses, though very poor countries may run an account deficit, which they’re unable to exploit given less developed financial markets.
A deficit in the current stronger U.S. dollar environment can be detrimental for emerging markets (VWO) in that a weaker currency has less purchasing power. So imports reduce, as they’re apparently more expensive. This has a direct impact on the inputs costs for many industries.
As margins squeeze, earnings drop and foreign investors start pulling out of their investments. As investments are liquidated, foreign investors sell the local currency to transfer their gains or losses to their home currency, putting further downward pressure on the local currency.
Finally, as the local currency weakens, the sovereign bond spreads wider given the higher risk of holding bonds in the local currency. This means that the cost of funding for the government increases, and the higher cost of debt cascades through the banks and the economy in general. The tighter lending conditions lead to reduced investment and reduced growth.
The following sections explain why the current account deficit in Indonesia (IDX) may improve in the short to medium term, lessening the effects of a stronger U.S. dollar.