Listen to this article
For a brief moment in 2007 Gisele Bündchen became the fetching face of dollar doomsayers, when her agent revealed that the Brazilian supermodel would prefer to be paid in euros rather than the struggling US currency.
At the time it seemed like a sensible move. Dollar-bashing was all the rage. Even rap stars waved wads of euros instead of the usual “Benjamins” – $100 bills. But after the onset of the financial crisis in 2008, the dollar defied the sceptics as investors swallowed misgivings and dived into everyone’s default safe place: US government bonds. Even as the Federal Reserve printed $2.5tn to prevent a financial collapse, the dollar stayed stable.
Now that the US is haltingly climbing out of its economic morass and the Fed is beginning to unwind its monetary stimulus programme, strategists and investors are predicting another golden age for the US dollar. This could have far-reaching implications for the developing world, including Ms Bündchen’s native Brazil.
Previous periods of dollar strength have been accompanied by crises in emerging markets. In the 1980s and 1990s the currencies of many countries collapsed when pegs to the dollar snapped under pressure, and the effective burden of dollar-denominated debts soared. Many countries were forced to default and chaos ensued. Assuming the dollar bulls are correct, will it prove equally calamitous this time round?
Many economists fear so. “Emerging markets have a lot to worry about from a resurgent dollar,” says George Magnus of UBS. “Lightning rarely strikes the same place twice, but they are still very vulnerable.”
Already there are disquieting signs. When the Fed discussed plans to reduce its monetary stimulus programme last summer, it triggered mayhem across the developing world, sending emerging market currencies tumbling against the resurgent dollar. The Fed finally followed up on its promise to “taper” quantitative easing in December, leading to a further strengthening of the dollar and more turbulence in emerging markets. A poor jobs report last week weighed on the greenback but it has already climbed 1 per cent this month and more is expected in the coming year.
“If history is any guide, a strengthening US dollar is bad news for developing countries,” says Michael Riddell, a fund manager at M&G Investments. “I think we are still at the tremor stage and we may be stuck here for a while but ‘the big one’ is still to come.”
Nonetheless, there are strong arguments that most emerging markets are better prepared for a dollar bull market than in the past.
Emerging markets have previously suffered because of a phenomenon economists call “original sin” – the inability of developing countries to borrow from foreigners in their own currencies. That meant most local companies, banks and governments were forced to borrow in dollars.
Many countries therefore fixed their own exchange rates to the US currency. But that often proved untenable when the dollar strengthened. When they were forced to devalue, the cost of dollar debts sometimes became so high that many were bankrupted, deepening the financial turmoil.
Original sin, however, has receded as many governments have gradually weaned themselves off the addiction to dollar debt since the 1990s crises. The larger developing economies such as Brazil and South Korea now have deep local markets that have become their primary funding tool. Overall, the developing world’s local bond markets have swelled to about $10tn and can act as a crisis backstop. This proved a boon for many emerging markets during the last financial crisis: they could simply borrow locally when international finance froze.
Moreover, most currencies are now allowed to fluctuate, providing an additional pressure valve in crises. Further depreciations would make emerging market exports cheaper and claw back some of the competitiveness lost in recent years. Central bank reserves have been bolstered to provide additional insurance. Emerging countries had a financial war chest of almost $7.5tn by mid-2013, up from $1.2tn a decade ago.
Jan Dehn, head of research at Ashmore, an investment group that specialises in emerging markets, argues that the developing world therefore has little to fear.
Last year’s turmoil was simply the result of investors “acting like headless chickens, running from one side of the coop to the other”, he says. “It is entirely possible that emerging markets will be the best performing asset class in the world [this year].”
Nonetheless, all is not rosy in the developing world. Investors have in the past decade poured money in because of much better economic fundamentals, but those have actually deteriorated markedly since the financial crisis. Quantitative easing in the US masked the tentative cracks but as the Fed begins to reduce its stimulus, faultlines will be exposed. Higher borrowing costs globally will hurt countries that have grown accustomed to cheap debt. But many economists expect a resurgent dollar to pose one of the biggest tests of emerging-markets mettle in the coming years.
Original sin may have been ameliorated but it is far from eliminated.
The average percentage of government debt denominated in a foreign currency peaked at almost 80 per cent in the early 1990s but still stood at roughly 46 per cent last year, according to research by David Riley of BlueBay Asset Management. That is a big improvement but indicates that the many governments will face an increased debt burden if the dollar resurgence gathers pace.
Moreover, original sin comes in many guises. While countries have curtailed their dollar borrowing, international money has gushed into their local bond markets. Analysts at Morgan Stanley argue that the “dramatic” increase in foreign holdings of local bonds is another manifestation of the phenomenon.
Countries may no longer borrow much in dollars but they are still dependent on foreigners for funding – a vulnerability that could be exposed by a resurgent dollar. In some markets, such as Malaysia and Mexico, international investors control almost half the domestic government bond market.
A lot of the investment will be “sticky” but if the dollar’s prospects brighten and emerging market currencies wilt further, many money managers will be tempted to pare their holdings, pushing borrowing costs higher.
Even international investors that still want to keep their money in local emerging bond markets because of higher potential returns will be tempted to “hedge” – or buy insurance against – currency declines. That may moderate the rise in borrowing costs but weigh further on emerging-market currencies.
“Borrowing in domestic currencies only takes you so far,” argues Kenneth Rogoff, economics professor at Harvard University. “You are clearly still vulnerable when there is a lot of foreign money in your bond market.”
The development of local bond markets is unquestionably a boon but for most countries it is no panacea. Of the almost $10tn worth of locally denominated bonds, almost two-thirds are in Brazil, China and South Korea. Many countries and companies are still forced to borrow in dollars because of the shallowness of their domestic bond markets.
Moreover, after a long period of rising wages, prices and exchange rates, many developing countries now have less competitive economies and current account deficits. Brazil, for example, has moved from a healthy surplus to a trade deficit since 2008. This means Brazil is dependent on dollar inflows to prevent balance of payments problems.
Perhaps the biggest dangers might lurk out of sight in the private sector. Since 2007 emerging market companies and banks have issued more than $1.2tn of bonds – a splurge Christine Lagarde, the International Monetary Fund managing director, noted with alarm last year.
Companies tend to hedge against currency fluctuations that will increase their debt burden but many do not. Some analysts fear the dollar’s long weakness has led to complacency among corporate executives. For example, Morgan Stanley estimates that half of India’s $225bn corporate bonds are unhedged.
“Many countries remember the lessons of the past crises. But there is a whole generation of entrepreneurs and CFOs who have never learnt those lessons,” says Andrew Sheng, a former central bank official and regulator in Hong Kong at the time of the 1997 Asian financial crisis who is now president of Fung Global Institute, a think-tank.
In a severe crisis this in turn can lead to systemic problems, as corporate failures hurt banks and eventually the country itself. “Big devaluations tend to reveal unknown problems,” Prof Rogoff observes. “That’s why the situation is so scary.”
While most developing countries theoretically allow their currencies to trade freely, given the risks to financial stability many central banks have intervened directly and aggressively in markets to ease pressure on their exchange rates.
For some countries this has barely dented their foreign currency reserves, buttressed after many years of trying to keep the strength of their currencies muted. But some countries have not stashed all of the boom-time money away. Last summer’s turmoil severely stretched the coffers of countries such as Ukraine, Turkey and Indonesia. These and others have been forced to keep or raise interest rates higher than they would have liked, to staunch currency declines.
The danger is that reserves become further depleted this year as the dollar’s recovery gathers pace. For some countries this could be a vain pursuit that merely erodes their financial health and worsens their predicament: central banks tend to sell US Treasury holdings to support their own currency. If they sell large amounts of Treasuries, US bond yields would rise further and rattle their markets – a negative feedback loop that some analysts said was already apparent in last year’s turmoil.
There is also an economic cost in trying to stem the declines against the dollar. Attempting to keep up with the greenback’s rise could deepen the competitiveness loss that emerging markets have suffered in recent years, economists point out.
Although original sin has receded, “we shouldn’t be celebrating quite yet”, argues Guillermo Calvo, an economics professor at Columbia University and an expert on emerging market crises. “It’s true that the share of debts in domestic currency is much higher than it was but if you try to resist a currency devaluation it might as well all be in a foreign currency,” he says.
A dollar renaissance is unlikely to prove as agonising as it did in the past. The biggest risk in 2014 is going to be the more immediate impact that the Fed’s unwinding of its quantitative easing programme will have on global borrowing costs. Chinese economic growth – a big driver of emerging economies – is another wild card. But a stronger dollar will not prove painless and policy makers in the developing world should not be complacent.
As Mr Sheng ruefully notes, with his bruising experience of the Asian financial crisis in mind: “The main lesson is to never underestimate financial fragilities.”
Tequila crisis: The dangers that only come to light in a disaster
Mexico’s “tequila crisis” is the quintessential example of the dangers of original sin. It also holds some cautionary lessons for those who believe the floating exchange rates and foreign borrowing abstinence of emerging markets will now inoculate countries from crises.
Money gushed into Mexico in the early 1990s but when Alan Greenspan, the Federal Reserve chairman, raised interest rates in 1994 the boom came to an abrupt end – and the dollar put pressure on the peso’s peg. By December the government tried to depreciate the peso but the currency crashed by more than 50 per cent.
The government was then brought low by its Tesebonos – peso bonds indexed to the dollar to reassure investors worried about a devaluation. When the peso collapsed the state was unable to pay the Tesebonos and had to be rescued by the US and the International Monetary Fund.
Today Mexico’s finances are transformed. About 80 per cent of its debts are in pesos, the currency floats and the central bank’s reserves are close to $180bn. Original sin is almost eliminated and the country is a firm investor favourite.
But the tequila crisis holds another vital lesson for policy makers and investors that draw comfort from the striking reduction in original sin: that there is often an unknown vulnerability that only comes to light when a crisis erupts.
Mexico’s crash in 1994 was exacerbated by the fact that the recently privatised local banks had themselves quietly accumulated huge exposures to Tesebonos. The currency devaluation therefore hammered the entire domestic banking sector instead of just hurting US banks, causing a ripple throughout Latin America.
Nor did Mexico look particularly vulnerable before the crisis struck. Although the current account deficit was wide and inflation elevated, the budget was not in terrible shape and growth was the fastest in four years in 1994. “Mexico was the poster child of Latin America,” says Prof Calvo. “But when liquidity bubbles burst it reveals weaknesses we cannot see now.”
Get alerts on Central banks when a new story is published