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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Emerging markets face tough sledding

In the aftermath of the pandemic, most analysts expected the emerging market economies to outperform given attractive valuations and rapidly expanding demand for their exports as the developed world went on a buying spree. That optimism has not been rewarded, and the outlook is dimming thanks to headwinds that may augur ill for the emerging world and especially for its smallest and poorest nations.

The term “emerging markets” describes a subset of foreign nations whose economies are not fully mature but are experiencing relatively rapid growth and industrialization as they evolve away from their traditional subsistence orientation. Given their high rates of expansion from a lower base, these countries often display high volatility that can be rewarding over time to investors willing to endure the ride but can also slide quickly into prolonged declines in response to global macro factors. The risks of the latter appear to be quickening thanks in large part to the outsized role of the US Dollar.

In preparing for the post-war reconstruction of the world economy, Allied leaders gathered in 1944 at the Bretton Woods conference to craft a new financial system based upon the only large and stable currency then in existence, the US Dollar. Over time, the system became unworkable due to the limited supply of gold, and by 1973 President Nixon had decoupled the Dollar from the gold standard. Most nations no longer pegged their currencies to the Greenback, yet it maintained its prominence as the de facto currency for international trade. Even today, the US Dollar is a participant in 90% of all foreign exchange transactions, 40% of all merchandise trade, and most commodity quotes including crude oil.

This reliance on the American currency, derisively dubbed the “exorbitant privilege” by a former French finance minister, has allowed the US to sustain massive trade and budget deficits without incurring the condign fiscal penalties. However, other nations without such immunity often see their own economic distress magnified during period of Dollar strength. 

When we speak of a rising or falling Dollar, we really are discussing the relative exchange value between the Greenback and another sovereign currency. A falling Dollar equates to rising Yen, Euros, Swiss Francs, or Polish Zlotys.

Two factors have boosted the Dollar to its highest value in 20 years: flight to the relative safety of the Dollar as the global risks increase, and the Fed’s aggressive rate hikes intended to curtail inflation in the US. And while a stronger US currency is generally beneficial to American consumers, it can have decidedly negative implications for other nations.

Nowhere is this more evident than in the emerging world.

By 2021, the inflationary spiral was already punishing lower- and middle-income countries. In the wake of Russia’s invasion of Ukraine, energy and food prices were consuming higher shares of government budgets. To procure these more expensive commodities, the governments had to either buy Dollars to pay for the goods or spend down their own Dollar reserves.

Observe the double whammy: buying more expensive Dollars to purchase more expensive oil. That alone was enough to depress growth in the EM world, but that’s not the whole story.

Nations also use their Dollar reserves to support their own currencies. Recall that a stronger Dollar equates to weaker native currency, reducing local purchasing power and worsening inflation. EM countries have resorted to selling some of their Dollar holdings to defend their own currencies in an effort to avoid a hyperinflationary devaluation. This has also sharply reduced Dollar reserves.

Additionally, emerging nations borrowed heavily from foreign lenders to prop up their economies during the pandemic recession. Many, out of necessity, borrowed in Dollars and must now repay interest and principal in much costlier Dollars, further siphoning their USD reserves and in some cases sucking them dry. Sri Lanka, Lebanon, and Zambia have already defaulted on their foreign debt, and some larger nations including Pakistan and Turkey are seeking relief from the IMF. According to The Economist magazine, there are currently 53 nations either in debt distress or likely to fall into distress before the situation improves.

And as if these challenges were not enough, a stronger Dollar causes capital to flee from the Emerging world to the US where yields and investment returns are now higher. This capital flight reduces domestic investment and impedes economic recovery.

And then there’s China, which comprises 40% of the MSCI Emerging Market index and is beset with more challenges than can be recounted here. Suffice it to say that the zero Covid policy, catastrophic drought, authoritarian crackdowns, demographic constraints, and a massive real estate bubble will challenge the Asian colossus to maintain even modest growth into 2023. And thanks to Chinese loans to EM nations as part of its overly ambitious Belt and Road initiative, fully 1/3 of all distressed sovereign debt today is owed to Beijing. President Xi may attain lifetime leadership at October’s Party Congress, but he’ll have to work for it.

If not identical, the pattern is redolent of previous EM crises of the 80s and 90s in Asia, Latin and Central America, and Mexico. All were precipitated or exacerbated by the rapid strengthening of the Dollar and required considerable time to recover.

Opportunity and risk are intimately intertwined, and expected returns over an extended horizon favor exposure to emerging markets. But there are significant challenges in the developing world that may demand patience from long-term investors.

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