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Analysis > Analysis and Strategy

USD improving EM competitiveness

Jan Dehn, Head of Research, Ashmore
Oct. 16, 2015, midnight

Word count: 1311

Jan Dehn, Head of Research at Ashmore, discusses why the rise of the USD in the past few years is now helping to restore competitiveness in Emerging Markets (EM) countries

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Jan Dehn, Head of Research at Ashmore, discusses why the rise of the USD in the past few years is now helping to restore competitiveness in Emerging Markets (EM) countries

The US now faces exactly the type of issues many argued posed a threat to EM countries a few years ago, namely an overvalued exchange rate, lack of reform, a current account deficit and declining productivity. Roles have been reversed. The slowdown in global growth can mainly be attributed to the severe misallocation of global capital caused by Quantitative Easing (QE) policies.

The strong USD of the past few years imposed numerous drags on both the US and EM economies alike. The strong USD was very valuable to the US in the first few years after the subprime crisis, because the US needed to finance big deficits by selling government bonds to foreigners. But this need is now less urgent and meanwhile the strong USD has now rendered the US economy very uncompetitive, struggling with an overvalued exchange rate, asset bubbles, a widening trade balance and declining productivity. In EM, many countries were also adversely impacted by the surge in the USD, because the resulting weakness of their own currencies encouraged flight of foreign investment capital, lower commodity prices and loss of investor confidence. But in a mirror image of what has happened in the US, the stronger USD has now slowly begun to impart benefits on EM countries by improving their competitiveness, particularly because so many EM countries managed to avoid pass-through of weak currencies to inflation. In other words, EM suffered from outflows in the capital account, but gradually regained genuine real effective exchange rate depreciation which is now improving their current account positions.

A misallocation of global capital due to QE

The IMF last week made significant downwards revisions to global growth (-0.6% for 2015 and 2016). The downwards revisions make eminent sense in light of the USD rally of the past few years and the resulting direction of capital flows. QE policies – and how financial markets have chosen to trade in response – have been deeply counter-productive. By drawing capital to developed markets, they add further to already overvalued asset prices and excessive debt stocks and thereby worsened the global imbalances that lie at the heart of the crisis of 2008/2009. The flows into developed economies also appreciated currencies in countries that in fact need weaker currencies in order to rotate from excessive reliance on debt fuelled domestic consumption towards export led growth. Productivity gains have become more elusive, not less so. QE has, for lack of a more diplomatic phrase, ensured that even more good money was thrown after bad. No wonder growth has been so pathetic despite hyper-easy monetary policies.

Global growth has also been impeded by a slowdown in growth in EM, although it is noteworthy that the IMF revised down the US growth for 2015-2016 by 60% more than the growth rate for EM countries (-0.8% versus -0.5%, respectively). The misallocation of global capital due to QE is directly to blame. Many global asset allocators jumped on the QE bandwagons set in motion by the central banks of the developed world and reduced their allocations to EM. This inflicted financial tightening on the healthiest part of the world economy and thereby undermined rather than encouraged the very growth engines that had the potential to drive a global growth recovery.

Given the enormous exercise in resource misallocation orchestrated by QE central banks over the past few years, what is the outlook for EM and the US from here? It is almost the inverse of what it was four years ago. The US must now find a way to restore competitiveness, either by reforming or, if that is not possible, by devaluing its currency (hoping as it does so that it can control inflation like EM countries have done). Reforms look unlikely and a big decline in the USD would be traumatic, to say the least, given the enormous exposure to the Greenback across the financial world. EM countries arguably now face a somewhat less daunting outlook. They have been through a lot of the pain, their real exchange rates are now competitive and this is already showing up in better current account numbers. The slowdown in EM growth over the past few years has brought about this change, fortunately without enormous casualties in terms of sovereign defaults, balance of payments crises and even growth rates (there are not that many recessions anywhere in EM). Most ‘crises’ in EM, such as Brazil, are self-inflicted problems and ultimately cyclical rather than structural in nature. Just as India’s challenge two years ago and Russia’s challenges last year were cyclical in nature.

Expect a non-linear rotation back into EM

The remaining question is this: Having now cheapened significantly on the back of real economic adjustment will investors now recognise that the rational way to allocate capital is out of QE markets and into non-QE markets? We guess probably not. Value has never been a major driver of flow in EM. In a very herd driven market beholding to rules of thumb what is typically more important for flows into EM is that others are allocating too. This suggests that investors will probably rotate back into EM in a highly non-linear fashion.

Smarter and better educated investors are already allocating, but others are bound to chase the rally long after it has started. One potential serious drag on flows to EM right now is that the core allocations to stocks and bonds in developed markets are not doing so well this year. These allocations make up more than 90% of most investors’ portfolios (EM is still a far smaller part of most portfolios than justified by either market cap or GDP weight). If these core portfolio positions are under water, investors will be nervous and nervous investors tend not to allocate to EM with great gusto.

This is bound to change, but probably not yet, barring a sudden serious collapse in the USD. Perhaps the most important driver of flows to EM will be that losses in non-EM positions begin to sustain far more serious losses. Bond and stock prices in developed economies are held up by trillions of dollar worth of hot air and increasingly fragile confidence in the Fed and other central banks. When confidence in QE central banks fails or inflation returns money will flee those markets in favour of the non-QE world in much larger volumes. Markets are almost certainly not going to be adequately prepared, so the door will be narrow.

USD weakness a respite for commodities

The recent weakness in the USD is providing respite for commodities. A big reason why commodity prices fell in the past year was the USD surge. If the USD is peaking, even if it is just levelling off here, it will itself make the outlook for commodities more stable. Eventually, however, as the QE currencies, including the USD, are bound to fall this bodes well for commodities over the longer term. On that view, EM countries will now have seen the worst of the commodity shock.

So as we have seen with other shocks – such as capital outflows and declining investor confidence – falling commodity prices are not as big a risk for EM as many people had expected. There are many reasons for this, but one of the most important is that many EM countries now produce manufacturing, industrial goods and services, or import commodities, while the specialised commodity dependent countries have often responded to lower prices with the correct set of policies, i.e. reducing domestic demand and adjusting the currency. Across the EM space, of course, the quality of the policy response has varied (from excellent in Russia to terrible in Nigeria). But the point is that the old cliché that all EM countries as near-exclusive producers of raw materials is just that, a cliché.

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