What to consider as currency volatility increases

Many investors are braced for greater market volatility in equity markets, and that caution should include consideration of emerging market currencies.

Read: The story behind emerging market outflows

Volatility on the foreign exchange market has been increasing since mid-April, with many emerging market currencies posting depreciations of 10% or more, notes a report by Desjardins.

The volatility is in part a reflection of monetary policy tightening by the Fed, which is driving up the U.S. dollar relative to other currencies, with negative consequences for emerging market economies.

“Rising interest rates mean that it will likely be more difficult for many emerging countries to attract capital,” says the report. “Businesses, government and households risk having a harder time getting funding,” which would result in a slowdown of economic growth.

The countries affected tend to be those struggling with debt, since they effectively take on more risk as global interest rates increase.

“The perception that these countries are more fragile causes investors to flee and increases exchange rate volatility,” says the report, citing Venezuela and Argentina as current examples. “Egypt, Brazil and India are other cases worth watching closely.”

Currency volatility is further reflected in growing risk aversion, recently fuelled by rising oil prices, the resurgence in financial tensions in the euro zone and growing protectionist measures, says the report, all of which could further dampen emerging markets’ economic growth.

The report also notes that lower exchange rates typically go hand in hand with higher inflation caused by an increase in prices of imported goods. Further, “If accelerating inflation is interpreted as a loss in the value of a currency, this can encourage its abandonment and result in further depreciation, potentially leading to an inflationary spiral.” The report adds that inflation is particularly high in Argentina (about 25% in 2017), Egypt (about 24%) and Turkey (about 10%)—all countries with depreciating currencies.

While the solution to control rising inflation is often to raise rates, tighter monetary policy strains economic growth, putting economies in a vicious cycle. “Growth that is too weak will worry investors, which may also result in further currency depreciations,” says the report.

Though many emerging market countries have refrained from raising rates, rising oil prices present potential inflationary pressure, as does protectionism—potentially presenting a dilemma for emerging market economies.

Despite recent currency volatility, the situation isn’t as dire as currency movements during the 1997 and 1998 financial crisis, when the Thai baht, for example, lost more than half its value in a few months, and the Indonesian rupiah lost more than 75%.

The report puts that era in context, saying that the crisis erupted after a period of overinvestment, when many countries had taken on too much foreign debt and were challenged to maintain their fixed exchange rate regimes.

Today, overinvestment is less of an issue, and external debt is much lower than in the 1990s, says the report. And, since there are fewer fixed exchange rate regimes, there’s also less speculation on potential devaluations. Further, many emerging market countries have accumulated international foreign exchange reserves to offset potential shocks.

Still, the potential combination of rising rates, inflation and protectionism has Desjardins advising investors to exercise caution.

With protectionism in particular, the bank points to China, which accounts for 18% of global GDP. If trade barriers escalate, the Chinese yuan will likely experience greater volatility, it says.

Read: What might cause trade tensions to ease

In a weekly economics report, CIBC senior economist Royce Mendes notes that, when it comes to trade exposure, a country’s exports as a percentage of GDP isn’t the sole metric to consider.

“It doesn’t only matter how much a country exports, it also matters how much of the value is generated locally,” he says. “The more domestic content, the more it is exposed.”

For example, less than half of South Korea’s export content is domestic, while almost all of Switzerland’s is.

“With trade concerns increasingly dominating currency valuations, it’s worth tracking where production is actually occurring,” says Mendes.

Read the full reports from Desjardins and CIBC.

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