By Frances Coppola
For some developing countries, such as Turkey and Argentina, currency exchange rate weakness reflects problems in the domestic economy.
However, because of the dominance of the dollar in global markets, currency volatility in other developing countries is also affected by policy changes in the U.S. The three policy areas that particularly influence foreign currency exchange rates are interest rates, the Fed’s quantitative easing (QE) via bond purchases, and U.S. Treasury debt issuance.
When U.S. interest rates rise, countries that peg their currency exchange rates to USD, or are export-led economies whose principal export is priced in USD, can be forced to raise interest rates in line with U.S. rates. If they don’t, they can suffer outflows of funds which put downwards pressure on their currency exchange rates. For example, the differential between Brazil’s interest rates and U.S. rates is narrowing as U.S. rates rise, which is causing the Brazilian real’s exchange rate to fall versus the U.S. dollar.6 Carry trades – FX trades made solely for the purpose of exploiting interest rate differences – can also strengthen the dollar and weaken other currencies.
However, according to Urjit Patel, governor of the Reserve Bank of India, the Fed’s interest rate rises are not the main cause of the current widespread turbulence in developing country currency exchange rates. He says the combination of the Fed’s shrinking balance sheet and the U.S. Treasury’s rising debt issuance is causing a shortage of dollars on global markets.7
The Fed has been gradually reducing the size of its balance sheet since the fall of 2017. It is doing so by allowing bonds purchased under its QE programs to mature without replacement. According to Patel, the Fed’s bond holdings are currently falling at a rate of $50 billion per month; by December 2019, the Fed’s balance sheet will be $1 trillion smaller. That means there will be $1 trillion fewer dollars in circulation.8
In parallel with this, the recent U.S. tax changes are set to increase the size of the budget deficit. To fund this, the U.S. Treasury is increasing bond issuance. Patel estimates that U.S. Treasury debt will rise to $1.171 trillion in 2019.9
So, just as the Fed reduces the quantity of dollars in circulation, the U.S. Treasury is creating additional demand for dollars. As a result, Patel says, “dollar funding has evaporated, notably from sovereign debt markets. Emerging markets have witnessed a sharp reversal of foreign capital flows over the past six weeks, often exceeding $5 billion a week.”10
Thus, outflows of capital from developing countries are causing their currency exchange rates to fall and their bond yields to rise. To counter this, Patel suggests that the Fed could slow down the pace at which it reduces the size of its balance sheet.11
However, the Fed’s mandate is to achieve price stability and full employment in the U.S. Currently, U.S. unemployment is low at 3.9 percent,12 and the Fed’s preferred measure of inflation is close to its 2 percent target.13 The Fed is forecasting further interest rate rises in 2018.14 It may therefore be unwilling to proceed more cautiously with balance sheet reduction, as keeping more dollars in circulation could prevent it meeting its inflation target.
If the Fed continues to shrink its balance sheet at the present rate, then currency exchange rates for developing countries could experience considerable volatility for some time to come. U.S. businesses that trade with developing countries, as well as import-export businesses in developing countries, may wish to consider ways of protecting themselves from rising FX risk in this turbulent trading environment.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “U.S. Trade-weighted Dollar Index (Broad),” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
2. “Consumer Price Index, Main Statistics,” Turkish Statistical Institute; http://www.turkstat.gov.tr/UstMenu.do?metod=temelist
3. “Turkey Government Bonds,” Investing.com; https://www.investing.com/rates-bonds/turkey-government-bonds
4. “Why Argentina has returned to the IMF – in charts,“ Financial Times; https://www.ft.com/content/cf13acba-6aa2-11e8-b6eb-4acfcfb08c11
5. “Argentina agrees $50bn financing deal with IMF,” Financial Times; https://www.ft.com/content/cf13acba-6aa2-11e8-b6eb-4acfcfb08c11
6. “Brazil FX: What’s driving the real’s underperformance?” Euromoney; https://www.euromoney.com/article/b17xbbclfrs6bp/brazil-fx-whats-driving-the-brls-underperformance
7. “Emerging markets face a dollar double whammy,” Financial Times; https://www.ft.com/content/e193381a-64c1-11e8-bdd1-cc0534df682c
12. “U.S. unemployment rate,” U.S. Bureau of Labor Statistics; https://data.bls.gov/timeseries/LNS14000000
13. “PCE inflation,” FRED Economic Data; https://www.baudville.com/resourcecenter2/article.aspx?id=514
14. “Federal Reserve Board Economic Projections, June 13, 2018,” Federal Reserve Board; https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf