Despite the recent Banking crisis, increased attention around inflation and rising interest rates in the US, the USD is not going anywhere as the world's reserve currency any time soon. Why is that and what does this mean for emerging markets?
What about Europe? Can the UK or EU provide a meaningful world currency in GBP or EUR? A year ago Europe had negative interest rates and was still figuring out how it was going to get out of the long standing issues it still had with the problems created during the 2008 financial crisis. Now it is trying to tackle inflation which is only going to be further affected by the need to react and support eastern Europe during and after the war with Russia is over. Military spending and rebuilding Ukraine won’t come cheap and wasn’t in anyone’s budget. Europe has to figure out how to solve its own problems without the US.
The UK economy by contrast, is still trying to figure out what it wants to be in a post Brexit world. The new Silicon Valley? Who knows, but one thing is certain, the UK economy and its 70 million population just isnt big or strong enough to support a world currency which isn't setup to facilitate international trade. It is setting itself up for capital inflows instead, which it desperately needs after so much of it flew out post Brexit.
The GDP growth seen by China over the last few decades has been phenomenal and their approach to economic plans such as their Belt and Road road initiative, mean that they can take meaningful steps towards 50 year plans that don’t get hijacked by bipartisan politics like the constant debt ceiling debates we see in the US. Could China provide a solution to a world currency? Currently, China controls its economy very closely and decides how much liquidity to provide to its banks, which are some of the biggest in the world. Opening up the currency to international markets would essentially remove central control. In other words, that feels one step too close towards becoming a free economy that I can't see happening any time soon.
As a result, most world trade will continue to be settled in USD and this has knock on implications for Emerging Markets all over the world.
Emerging market currencies are those of countries that are in the process of developing their economies and are often seen as riskier investments by international investors compared to more established, developed economies like the United States or Europe. As a result, these currencies often experience devaluation compared to the US dollar for several reasons.
Trade imbalances:
Emerging market countries often have trade imbalances, meaning they import more than they export. Given international trade is settled in USD, this creates long term currency devaluation. For example, let’s say country X imports oil from country Y. Even though that import is most likely to not be from the US, it’s most likely settled in USD, for example. If country X isn’t exporting enough goods to other countries in USD and receiving USD then you don’t have USD in your balance sheet to pay for imports. You have to sell your local currency to buy USD to settle and pay for the import, so if you are always selling local currency to buy USD, you are devaluing your own currency against the USD. You are not creating any demand for the local currency which ultimately weakens it.
Political instability:
But surely Emerging Markets are resource rich and can export, especially oil? Emerging market countries may experience political instability, such as coups, civil unrest or changes in government, that can cause a loss of confidence in their economies. It can cause disruption to the supply chain, and make exports harder and therefore, slow down the economy. Venezuela is probably the best example of a country that despite having massive oil reserves, finds its economy devastated by political instability. Investors don't like instability and as such are most likely to move their money out of these countries and into safer investments, such as US dollars, which can lead to devaluation of emerging market currencies.
Interest rates:
Emerging market countries typically have higher interest rates compared to the US in order to attract foreign investment and because their currency is riskier than developed countries because they are more likely to default on their debt. However, when the US raises its interest rates, investors may move their money out of emerging market countries and into the US, causing the value of the emerging market currencies to decrease. The appeal of investing in an emerging market is diminished because on a risk adjusted basis, you can make similar returns in other markets while taking significantly less risk.
Lack of liquidity:
Emerging market currencies may have a limited supply and demand compared to the US dollar, which can make them more volatile and susceptible to sudden drops in value against the USD. Not many countries have the economic depth to be able to compete against the USD on this front. If you have a strong economy but have a trade deficit, you are flooding the market with your currency and weakening it. If you have limited liquidity for your currency overall, your currency is going to be very volatile against the USD.
External debt:
Emerging market countries may have significant external debt denominated in US dollars. Issuing debt in USD is seen as a good way of attracting capital inflows but it also means you have to repay interest on that debt in USD. If the value of their own currency drops, it can make it more difficult for these countries to service their debt, leading to a vicious cycle of further devaluation.
None of the above reasons happen in isolation. What we often see is that they compound each other in terms of creating a downward spiraling effect that is very difficult to get out of. Most Emerging Market currencies suffer a combination of the above issues which is why it is hard to think of a single currency from an emerging market that has not devalued consistently against the USD over the last 30 or 40 years. The only exception is probably Singapore and the SGD, but just land at Changi airport and take a taxi ride into town and nobody in their right mind would consider Singapore an Emerging Market anymore. They are the Switzerland of Asia, where wealth is being amassed in staggering numbers.
It is important to note that while emerging market currencies may experience devaluation compared to the US dollar, this is not always a negative thing for these countries. A weaker currency can make their exports more competitive and attractive to foreign buyers, leading to increased economic growth. However, sustained and severe devaluation can also lead to higher inflation and increased borrowing costs, which can hurt the economy.
The devaluation of emerging market currencies compared to the US dollar is a complex issue with multiple factors at play. While it can provide economic benefits in the short-term, it can also lead to long-term consequences that must be carefully managed by these countries.
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