By Frances Coppola
As part of a series examining the problems that the strong dollar is causing for selected developing countries and the reasons each country is particularly vulnerable, this first article identifies some general conditions that can make developing countries more at risk when the dollar exchange rate rises.
A country’s current account is its income from external sources. It incorporates the trade balance, which is income from exports minus expenditures on imports. But it also includes non-trade income, such as investments overseas and remittances from overseas workers. Therefore, it is possible for a country to have a current account surplus despite a persistent trade deficit (which means the value of its imports exceeds the value of its exports).
The mirror image of the current account is the capital account, which records a country’s inward foreign investment. The capital account includes stable long-term investment in local businesses and infrastructure, but much of it may be short-term speculative investment, particularly if the currency exchange rate and/or interest rates are high.
Because the capital account records the external borrowing needed to fund the current account, it is necessarily in surplus if there is a current account deficit. The risk is that if the country’s currency exchange rate falls, those investing in that country may pull their funds. This is known as a “sudden stop.”1 As the country becomes desperately short of the foreign currency needed to pay for imports, imports crash. As a result, both the capital account and the current account are forced into balance.
Loss of foreign currency due to a sudden stop can cause widespread bankruptcies if companies and households have borrowed in foreign currency. Additionally, if the government itself has borrowed in foreign currency, it may have difficulty servicing its debts.
For developed countries, borrowing in their own currencies is the norm. Although countries such as the U.S. and U.K. have high external debt,2 their ready access to foreign-exchange markets and swap lines helps ensure that they can always obtain foreign currency by simply exchanging it for their own currency. Consequently, developed countries don’t tend to have large amounts of foreign currency debt compared to the size of their economies.
But this is not the case in developing countries. Many lack the historical credibility to borrow long-term in their own currencies, so they are forced to fund fiscal deficits in foreign currency. Economists call this “original sin.”3
Borrowing in foreign currency leaves a government vulnerable to default if the country’s exchange rate falls significantly. Although a government can issue unlimited quantities of its own currency, it cannot guarantee it will be able to exchange enough of it on the open market to meet its debt obligations. If a developing country has both current account and fiscal deficits (a phenomenon known as “twin deficits”4), exchange rate falls can result in debt default and severe economic damage.
For a developing country that suffers from original sin, therefore, running a balanced government budget and a current account surplus can help prevent an economic crisis due to the strong dollar.
In the Asian crisis of 1997/98, some developing countries in the region experienced sudden stops and debt default. Since then, many Asian developing countries have run sustained current account surpluses and built up sizable FX reserves as a buffer against sudden currency exchange rate depreciation.5
FX reserves can protect a country from exchange rate volatility in several ways. Central banks can use the reserves to intervene in FX markets to smooth out sharp exchange rate swings, creating more certainty for businesses and thus helping to maintain import-export trade levels when exchange rate risk is high. Alternatively, the central bank can sell down FX reserves to support a falling currency exchange rate, though this tactic is not always successful: markets know that FX reserves are not infinite, and sometimes currency speculators launch determined attacks that can quickly drain reserves.
FX reserves can also be used to support domestic banks when demand for foreign currency rises—for example, if businesses need to obtain more dollars to meet debt obligations and pay suppliers. Up to a point, FX reserves can be used to meet external sovereign debt obligations, though again the risk is that they will run out. In general, the larger a developing country’s FX reserves, the better it is protected from the negative effects of a rising dollar exchange rate.
As investors tend to react negatively to an economic crisis, a country that has sufficient FX reserves to protect itself from adverse exchange rate movements is less likely to suffer a sudden stop. In recent years, the currency exchange rates of developing countries with substantial FX reserves have tended to fall less against the dollar than the exchange rates of developing countries with thin buffers.6
Countries with current account deficits, large amounts of private and/or sovereign debt denominated in foreign currencies, and low FX reserves are the most vulnerable to debt default and economic crisis when the dollar exchange rate is rising. International businesses may want to keep a watchful eye on the financial soundness of countries with which they plan to do import-export trade.
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. “Capital Flows and Capital Market Crises: The Simple Economics of Sudden Stops,” Calvo; http://www.columbia.edu/~gc2286/documents/ciecpp5.pdf
2. “Countries With The Most External Debt in 2017,” Global Finance Magazine; https://www.gfmag.com/global-data/economic-data/xtegh9-external-debt-in-countries-around-the-world
3. “The Pain of Original Sin,” Eichengreen, Hausmann & Panizza; https://www.gfmag.com/global-data/economic-data/xtegh9-external-debt-in-countries-around-the-world
4. “Twin deficit hypothesis,” LearnEconomicsOnline; http://learneconomicsonline.com/blog/archives/494
5. “What Asia learned from its financial crisis 20 years ago,” The Economist; https://www.economist.com/finance-and-economics/2017/07/01/what-asia-learned-from-its-financial-crisis-20-years-ago
6. “Rising Dollar Sparks Tumult In Emerging Markets,” The Wall Street Journal; https://www.wsj.com/articles/rising-dollar-sparks-tumult-in-emerging-markets-1526898426