The Deal on the Dollar: Divergence

Francis A. Scotland  – Director of Global Macro Research

Bad things tend to happen when the U.S. dollar rises too much. Unfortunately, there has been a lot of that lately, with most of it playing out in the emerging world, at least so far. The dollar is up a little more than 7% against other major currencies this year. However, the JP Morgan Emerging Markets Currency Index has fallen to a new low, down almost 15%. The iShares MSCI Emerging Markets ETF has tumbled 20% from its peak this year. Meanwhile, Turkey and Argentina are in crisis mode. Perhaps most important, the CRB Raw Industrials Spot Price Index is down for the year along with the MSCI Global Equity Index.

The emerging world’s systemic vulnerability to dollar strength derives from balance sheets and national income statements. The balance sheets of emerging market corporates are loaded with U.S. dollar-denominated debt, having taken advantage of cheap dollar credit fostered by unorthodox monetary policy in the developed world over the last 10 years. Systemic balance sheet risks and even specific idiosyncratic risks can lie fallow for long periods during which time foreign investors can earn a handsome carry. It takes a rally in the dollar for these vulnerabilities to manifest into investment losses and emerging market stress. In these instances, dollar strength weakens any emerging market-based borrower’s ability to service dollar-denominated debt. As for their income statements, those developing countries running large current account deficits are first in line when foreign lenders go on strike. When it comes to dollar strength and emerging market current account deficits, the lesson to foreign lenders from past crises is to panic early and panic often …