By James McCormack, Fitch

The strength of the US dollar is the single most important issue of the many facing emerging market (EM) economies. At the same time – and in some cases as a corollary of the dollar’s strength – they are struggling with lower commodity prices, increasing rates of inflation, heightened political and geopolitical risks, greater financial market volatility, large capital outflows and an extended period of weakness in global trade.

It is critical to consider nominal dollar incomes in assessing countries’ relative economic performance and prospects because the dollar continues to dominate the pricing of global commodities, the settlement of international trade, the extension of cross-border credit and the foreign reserve assets held by EM central banks. Although the international roles of several other currencies, including the Chinese renminbi, are expanding, there is no convincing evidence that the dollar’s supremacy is under any immediate threat.

Early 2016 macroeconomic performance does not at first appear to have started as badly, or with as much volatility, as global financial markets – although there are some important exceptions. Time will tell whether markets under pressure are reliably indicating an economic turning ahead, but a closer look at many of the larger EMs reveals that downturns in dollar terms are already well entrenched.

Broader and deeper than 1998-1999
Fitch estimates that dollar GDP for the 30 biggest EMs contracted by 6.6 per cent in 2015. Our latest GDP and exchange rate forecasts suggest that dollar income will fall again in 2016, and the combined two-year decline will be slightly larger than that of 1998-1999 (see Chart 1). The current episode is also broader than 1998-1999, with dollar GDP falling in 23 of the 30 largest EMs last year, compared to 16 in 1998 (see Chart 2).

There are three primary reasons for EM “dollar recessions”: lower commodity prices (more broadly, unfavorable changes in the terms of trade); dollar appreciation; and GDP contractions in local currency terms. Unfortunately for EM policymakers, two of the three – commodity prices and the dollar – are largely beyond their reach, although several central banks have made failing attempts to resist the strengthening of the dollar, running down foreign exchange reserves before giving way to overwhelming exchange rate pressures.

Where all three factors are at work, such as in Brazil and Russia, dollar recessions have been especially acute and are entering their third year. We forecast Brazil’s 2016 dollar GDP to be the lowest since 2007 after a 27 per cent decline last year. In Russia, dollar GDP fell by 35 per cent last year, and we project the 2016 level to be the lowest since 2006. It will be some time before either country achieves a full economic recovery in dollar terms.

Countries need not be affected by all three factors to experience severe dollar recessions.Colombia, Iraq, Kuwait and Ukraine also had dollar GDP declines of more than 20 per cent last year, and Fitch forecasts all to have small contractions in 2016 for the third consecutive year. Only Ukraine was in recession in local-currency terms in 2015, and both Kuwait and Iraq maintain exchange rates pegged to the dollar.

Of course not all EMs are net exporters of commodities, and a few are growing strongly in local-currency terms without significant exchange-rate pressure. For these countries, the three factors contributing to dollar recessions elsewhere are working in the opposite direction. Dollar incomes grew in India, the Philippines, Pakistan, Vietnam and Bangladesh in 2015, and we forecast them to expand again this year.

Back to the role of the dollar
For the majority of EMs between these extremes, with real GDP growth in local currency but falling GDP in nominal dollar terms, dollar recessions still matter based on the dominance of the US currency noted above. The more open the economy to international trade flows, for example, the more important its dollar GDP. A decline in dollar income caused by either a depreciation of the local currency or deterioration in the terms of trade is consistent with an effective reduction in global purchasing power. In these cases, real GDP growth in local-currency terms can feel much like recession.

In terms of capital flows, external borrowing is of most obvious interest, especially in light of the surge in EM external debt in the aftermath of the global financial crisis when US interest rates were exceptionally low and many EM currencies were appreciating. Now that US interest rates and EM currency trends have both changed direction, the burden of external debt service is rising accordingly.

More broadly, where there is persistent divergence between local-currency and dollar incomes, with dollar income lagging behind, foreign-currency debt service will account for an increasing share of local-currency GDP. This can be an important consideration for the external creditworthiness of EM sovereigns.

James McCormack is Global Head of Sovereign Ratings at Fitch Ratings

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