EM Economic Adjustment Through Fx
2015 has been a difficult year for the global economy. The S&P 500 is down 4.75% year to date and the MSCI World Index ex US is down 3.55%. A majority of the poor performance this year is due to weak growth in emerging markets. Traditionally emerging markets contribute more than 75% to global growth. However post financial crisis, global growth has been flat, most notably from China which is the largest contributor to global growth.
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Emerging markets have relied on rising commodity prices for economic growth. In 1999, oil prices were at $20 per barrel and the copper was at $60 per pound. At its peak, oil prices increased to $110 per barrel and copper increased to $500 per pound. During that time, U.S. rates fell to 2%. With the increase in commodity prices and accessibility to cheap capital, emerging markets underwent a long term economic structural change and increases government spending programs funded from increases in commodity prices. For example, Chile, a major exporter of copper, has increased output by 400%. The copper industry accounts for 10% of GDP and it impacts cascade to many other industries especially the government. EM countries have invested heavily in developing infrastructure to support increases commodity exports and started permanent government programs.
Emerging markets have been able to handle adjustments in previous crises but this adjustment will occur more so through currencies than previous economic adjustments.
The first reason for a greater translation through currencies is due to a shift in sovereign debt composition and FX structure. In the 1997 Asian financial crisis, countries were running a current account deficit and a fixed exchange rate. With a fixed exchange rate, EM countries lacked the flexibility to adjust interest rates. In addition, EM countries had large USD denominated debt making devaluation of their currency an expensive option due to increased debt servicing cost. In the previous EM crisis, a devaluation of their currency would cause a further deterioration of their fiscal account and risk the country’s credit rating. However now the landscape has changed dramatically. EM currencies have shifted to floating rates allowing for greater flexibility in currency adjustments and low USD denominated debt creates less risk for currency devaluation.
Secondly, as global trade declines and countries experience lower income, countries need to make internal spending cuts. A reversal in the increase in government spending programs backed by high commodity prices will be difficult and be extremely unpopular for politicians. With strong internal obstacles, competitive devaluation presents itself as an attractive option as it shifts stress away from unpopular fiscal adjustments and increases the competiveness of their exports.