Paris (AFP) – A rise in returns on US government bonds is provoking investors to pull money out of emerging markets, which is weakening their currencies and could provoke crises as they face a dilemma of accepting rising import prices and debt servicing costs or choking off growth with high interest rates.
Argentina, which raised interest rates three times last week to defend the value of the peso, is the first emerging market to have its feet held to the fire, but others such as Turkey are also under pressure.
When the rates of return on US government bonds fell a decade ago as the Federal Reserve sought to push money into productive investment and lending, many investors looked to emerging markets to earn higher returns.
Now, when earnings on US government bonds are climbing, many investors are moving their money back as they judge the higher returns in emerging markets to not be worth the added risk.
In just one week, from April 25 to May 2, the investors moved more than $1 billion out of emerging market debt, according to Bloomberg news agency.
During its annual meeting last month in Washington the International Monetary Fund warned of the danger that rising interest rates could cause turbulence in emerging markets, much like the 2013 “taper tantrum” when the Fed signalled its intention to wind down is stimulus measures.
“The process of the normalisation of monetary policy in advanced nations could provoke volatility in capital flows,” said Alejandro Werner, the IMF’s director for the Americas, said at the time. “It will be an important challenge for monetary authorities.”
While the Fed has wanted for years to return to a “normal” monetary policy where it can influence the economy via increases and cuts to interest rates instead of buying bonds, now that inflation has returned to its target level of 2.0 percent the US central bank has even more reason to push further in increasing interest rates.
While the Fed didn’t raise rates at its monetary policy meeting last week, it took note of the increase in inflation, and the markets expect it will continue to raise rates gradually.
– King dollar –
“Rising rates will certainly contribute to a rise in the dollar,” said Radu Vranceanu, an economics professor at the Essec business school outside Paris. “Thus it is logical there will be depreciations of emerging market currencies.”
They are already feeling the pressure as investors sell off their holdings and convert them into dollars.
The slide in the value of the currencies is quickly felt as prices of imported goods rise, with purchases of oil notably priced in dollars. This risks setting off inflation in countries such as India and Indonesia in particular.
The currencies of Brazil and Mexico have also suffered.
But for the moment, the hardest hit have been Argentina and Turkey, two countries where locals “don’t have confidence in their currencies and stampede for dollars at the slightest problem,” said Vranceanu.
Both countries suffered severe crises in 2001, with Argentina even defaulting on its payments.
“The markets get excited very quick and punish very quickly,” said Ludovic Subran, chief economist at Euler Hermes, a credit insurance firm.
– Dilemma –
Markets welcomed the victory of the liberal Mauricio Macri in Argentina’s 2015 presidential election.
Now, they are concerned about the ability of his government and the central bank to cut the inflation rate.
“They appear lost. They take one step forward and another back,” said Subran.
While Turkey may be more exposed to the eurozone and Argentina to the United States, the two countries share in common “an enormous current account deficit, strong interventionism, double-digit inflation. None of that is reassuring,” said the economist.
S&P Global Ratings has lowered its credit rating of Turkey. Argentina has raised interest rates to 40 percent to prop up the peso.
Emerging market countries face a dilemma.
If they don’t raise interest rates their currencies will slide in value, raising costs for imported goods and making it harder for repay dollar-denominated debt and loans.
If they raise rates the value of their currencies should remain stable but the high cost of borrowing will crimp economic growth.
“The best solution is to let the currencies depreciate,” said Joaquin Cottani, S&P Global Ratings’ chief economist for Latin America. “If the central banks raise their rates sharply to avoid a drop in value of their currencies that could interrupt the recovery” of their economies.
Will the trouble spread beyond Argentina and Turkey?
For the moment, Vranceanu believes there are just speculative reactions affecting other emerging markets.
“I don’t believe what is happening in the United States should create a widespread problem for emerging markets,” he said.