Not all crisis-fighting toolkits are created equal. Generally speaking, EMs don’t have the same capacity that DMs do for aggressive monetary and fiscal easing. That’s become apparent in the wake of the coronavirus pandemic. In recent months, the exceptional policy measures undertaken by EMs are starting to weigh on their currencies, as shown in this week’s Chart Room.
In aggregate, EM currencies have lagged DM ones in the global rally versus the US dollar. Since late March, EM currencies have appreciated on average by 2.1 percent through 1 Sept., compared with a 16.5 per cent gain for currencies from developed markets (those within the G20).
The weaker performance of EM currencies can partly be explained by higher inflation risks. Looking at consumer price index data from the past year, DMs have seen an average CPI increase of 0.5 per cent year-on-year, while in EMs consumer inflation has risen by 6.9 per cent. Even if we strip out Argentina’s 40 per cent surge in CPI (beyond the confines of the chart below), that still leaves an average 3.8 per cent rise in CPI among EMs within the G20.
Another factor in relative performance of a given currency is a country’s access to dollar liquidity. In the Covid era, the currencies of countries without US Federal Reserve swap lines have fared particularly poorly, specifically all the EMs except Brazil, South Korea, Singapore, and Mexico. The Fed set up these swap lines in March with 14 other central banks to offer emergency access to dollars. They help the recipient countries pay off their dollar-denominated debt and participate in global trade, while supporting the US government’s own borrowing by stoking demand for Treasuries.
The policy aims of most EMs have focused on stabilising their balance of payments and providing monetary and fiscal support to the private sector. But there is also a greater temptation to engage in monetary financing, where a central bank effectively gives money directly to the government to fund its fiscal spending. We’ve seen signs of this recently in Indonesia. Historically, this can lead to diminished investor confidence and heightened currency volatility, usually because the institutional frameworks in EMs were not robust enough to maintain financial system stability.
Investors concerned about rising inflation risk might consider rotating from local currency to hard currency EM debt, along with the use of currency hedges to reduce risk. Investing into emerging market inflation-linked bonds is also an option. These so-called ‘linkers’ have lagged their DM equivalents and could benefit from further currency devaluation and debt monetisation experiments.