Rising US dollar taking its toll on emerging economies

The emerging market economies never seem to learn from their repeated experiences with foreign exchange crises. Rather, they seem condemned to make the same policy mistakes that repeatedly get them into deep difficulty.

During the recent years of easy global money, they have proven, time and again, to be incapable of avoiding the temptation to over-borrow in foreign currency and let their currencies become overvalued. All too often, this leaves them exposed to any material tightening in global liquidity conditions and makes them a source of global economic instability when the credit cycle turns. 

As the Federal Reserve continues to hike interest rates, all indications point to a scenario not much different from the past for the major emerging market economies — Brazil, China, Indonesia, Russia, South Africa, and Turkey.

This is because they have behaved as if easy access to the international capital market would last forever. Easy money induced them to allow their corporate sectors to go on borrowing sprees and expose themselves excessively to foreign exchange risk. 

For some years now, the Bank for International Settlement (BIS), the central bank for the world’s central banks, has warned that excessive borrowing by the emerging market economies constituted a major risk to the global economic recovery.  

{mosads}What particularly concerns the BIS is not simply that emerging market corporations have more than doubled their overall indebtedness to around $25 trillion over the past eight years. Rather, it is that, during this same period, they have also managed to increase their U.S. dollar denominated debt by more than $3.5 trillion. 

Being as heavily indebted as they are, especially in U.S. dollar terms, the last thing emerging market economies need is a combination of higher U.S. interest rates and a strong U.S. dollar.

As has happened often in the past, higher U.S. interest rates would induce capital to be repatriated back to the U.S. from emerging markets at an accelerating rate. That would force emerging market currencies sharply lower and propel their interest rates higher, which, in turn, would substantially increase their corporate sectors’ already heavy debt service burden. 

It is also all too likely that a stronger U.S. dollar would depress international commodity prices, which are largely denominated in U.S. dollar terms. That could pose yet another serious challenge for a large number of emerging market economies, which remain overly dependent on commodity export earnings.

Unfortunately for the emerging market economies, under the incoming Trump administration, it is also likely that U.S. interest rates will rise significantly and the U.S. dollar will be propelled to ever-higher levels. The basic reason for this expectation is that President-elect Trump is proposing a substantial cut in corporate and household tax rates, while simultaneously proposing a large increase in both infrastructure and defense spending.

To make matters worse for emerging economies, President-elect Trump is proposing such an expansionary budget policy at the very time that the U.S. economy is close to full employment and wage inflation appears to be on the rise.

Should Congress go along with Mr. Trump’s tax and spending proposals, the Federal Reserve would have little option but to tighten monetary policy at a faster pace than it is currently planning to do.

Doing so would almost certainly cause U.S. monetary policy to become further out of sync with the central banks in Europe and Japan, where regulators are still engaged in very expansive unorthodox monetary policies. That would almost certainly send the U.S. dollar to new heights.

As if the prospect of higher interest rates and a strong dollar were not sufficiently bad news for the emerging market economies, they also now have reason to fear that the Trump administration will adopt a restrictive international trade policy.

Among the more consistent themes of Mr. Trump’s election campaign was the notion that the U.S. was being ripped off by foreign countries and a principal objective of his administration would be to reduce the trade deficit. This could be of particular concern for China and Mexico — countries Mr. Trump has repeatedly threatened to hit with import tariffs.

One has to hope that when the global credit bubble bursts, the emerging market economies will draw the right lessons as to how to manage their economies in a more prudent manner than they have done to date. However, judging by their long track record of poor adaptation to the global credit cycle, I am not holding my breath for this to happen.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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