Emerging market (EM) central banks are becoming increasingly sensitive to currency depreciation and several of them have sold a significant portion of their foreign exchange (FX) reserves to slow the pace of decline.
Most emerging markets have sufficient reserves to avoid old-fashioned crises, but further pressure on currencies could lead some to take more aggressive action to prevent further depreciation.
Swap lines and interest rate hikes are the most likely course of action; however, some may consider capital controls if the US dollar continues to rise.
South Africa is in a position of relative strength. While the rand is clearly not immune to a generally stronger US dollar, South Africa’s relatively strong fundamentals mean further currency depreciation is unlikely to cause panic. among policy makers.
The balance of payments is healthy, South Africa has been one of the few emerging markets to accumulate foreign exchange reserves over the past year, and the market is already pricing in a positive real interest rate.
Indeed, these factors are likely to attract investors once the global context has stabilized.
The resilience of emerging market currencies has often been overlooked in the current market chaos.
While the US dollar index (DXY) has appreciated by around 25% since mid-2021, emerging currencies that are not included in the DXY have generally fared less poorly.
Indeed, some – like the Brazilian real – delivered positive total returns against the dollar, supported by a combination of wide interest rate differentials, cheap valuations, light positioning and positive shocks to the terms of trade.
Tightening Forex Liquidity
However, liquidity in currencies – particularly in US dollars – is clearly reduced, as aggressive interest rate hikes in developed markets, deteriorating demand for exports from emerging markets and risk aversion sentiment led to capital outflows.
The high frequency data points to quite large outflows in recent weeks.
Central banks in emerging markets have clearly become more worried, drawing on their foreign exchange reserves to support their respective currencies.
In particular, the central banks of the Czech Republic, Chile and Thailand have seen their reserves fall by a fifth since the beginning of the surge in the US dollar.
To be fair, that is exactly why foreign exchange reserves are held.
They are accumulated during good times in order to be used during more difficult times. And it should be noted that the fall in reserves was exaggerated by a decline in the value of underlying reserve assets as developed market fixed income securities sold off.
Indeed, some estimates suggest that rising bond yields (and falling prices) accounted for more than half of the decline in emerging market foreign exchange reserves.
Intervening in the foreign exchange market by selling reserves can help avoid the kind of instinctive moves that tend to shake confidence in a country’s currency.
And having a large pot of reserves allows central banks to intervene longer and more aggressively.
However, while the sale of reserves can help smooth out exchange rate adjustments, policy rarely completely changes the direction of travel.
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Foreign exchange reserves are not a bottomless pit, which means that while most emerging markets have plenty of assets to avoid an old-fashioned balance of payments crisis, at some point direct intervention in foreign exchange markets become unsustainable if reserves become insufficient to cover external obligations.
As a result, further capital outflows and currency pressures are expected to force emerging market central banks to look for other ways to support their currencies and avoid a financial market dislocation that would hurt the domestic economy.
Policy makers are likely to consider three courses of action
Forex swap lines
The first is to secure the foreign exchange swap lines. These have historically been in place with the International Monetary Fund (IMF), and several emerging markets such as Mexico have had arrangements such as flexible credit lines in place for some time. This allows the central bank to supplement its reserves if necessary in times of crisis.
The Federal Reserve has also become more proactive in setting up swap lines with emerging markets during the pandemic era to avoid tensions in the US Treasury market, given that a sell-off of Reserve assets put upward pressure on yields.
There have been rumors that South Korea has sought to access a new swap line and other Treasury bond holders may be arranging.
Such swap lines can bolster confidence in the convertibility of a country’s currency, although, taken in isolation, they are unlikely to prevent further currency depreciation.
A second option for emerging market central banks looking for a more immediate way to stop currency depreciation is to make additional interest rate hikes. The hope is that by making investing in the local currency more attractive, capital outflows will decrease and some inflows will return.
The National Bank of Hungary (NBH) blinked last week when it announced a series of measures to support the Hungarian forint, including big increases in some of its interest rates. Although the BNH has not raised its official policy rates, it has aggressively raised other rates with the apparent aim of draining local liquidity, thereby driving up market interest rates.
In many ways, Hungary was an obvious candidate for “emergency” rate hikes.
It has relatively low foreign exchange reserves and a fragile balance of payments where its current account deficit is financed by short-term capital inflows. Additionally, market rate pricing is accommodative, which on a forward-looking basis is expected to remain low in real terms.
Under this approach, several other central banks in emerging markets – mainly in other parts of Central and Eastern Europe and Asia – may have to make significant interest rate hikes. These are needed in addition to those already priced on the market. These markets warrant an underweight in local fixed income.
The third option for central banks in emerging markets under severe pressure would be to impose capital controls.
The “impossible trinity” says that countries cannot have both a fixed (or managed) exchange rate, sovereign monetary policy and the free flow of capital.
On this basis, if central banks are unwilling to aggressively raise interest rates – or even seek to ease policy due to weak domestic activity – capital controls could be the order of the day. day.
Some emerging markets have already implemented capital controls for this exact reason, including China and others like Turkey may follow suit in the event of larger outflows.
Capital controls are no longer taboo and the IMF now believes they are justified in some cases.
However, it is a last resort for emerging market central banks given the long-term damage to credibility and is unlikely to be widely used.
David Rees is Senior Emerging Markets Economist at Schroders.