Market Insights

What Happens to Emerging Market Currencies During Stagflation?

Stagflation

Banks and other financial institutions in emerging markets are especially vulnerable to the prospect of stagflation caused by the repercussions of the Ukraine war.

As inflation rises, central bankers face growing pressure to tighten monetary policy. But will they be able to maintain inflationary expectations steady without suffocating the global economic recovery or precipitating debt problems, particularly in emerging economies?

Since the war in Ukraine began, bond rates in the United States have fallen, while global stocks have fallen by around 2%. Meanwhile, the Federal Reserve Bank of Atlanta's "GDP Now" prediction has dropped to zero for the first quarter of 2022.

Simultaneously, inflation is rising and is expected to be fueled further by rising global energy and commodity costs due to conflict, sanctions, and the potential of supply disruptions. It's no wonder that the term "stagflation" is becoming popular as the world grapples with the prospect of both slower economic growth and rising prices.

Stagflation Explained

In the 1960s, during a period of economic stress in the United Kingdom, MP Iain Macleod introduced the phrase "stagflation" when speaking in the House of Commons.

When discussing inflation on one hand and stagnation on the other, he coined the term "stagflation." It was later used to describe the recessionary period in the 1970s following the oil crisis, when the United States experienced five quarters of negative GDP growth. Inflation doubled in 1973 and reached double digits in 1974; unemployment reached 9 per cent by May 1975.

Stagflation resulted in the creation of the misery index. This indicator, which is just the sum of the inflation and unemployment rates, was used as a tool to show just how badly people were feeling when stagflation hit the economy.

How Does Stagflation Happen?

The combination of rising inflation and output declines is a condition central bankers and policymakers dread. Inflationary expectations are self-fulfilling prophecies. When consumers and businesses expect inflation, they demand higher wages and prices. Inflation is typically associated with weak economic growth, reflecting a decline in GDP growth and falling employment. These, in turn, tend to push down the profitability of firms, amplifying the weakness in output. With profitability falling, firms find it difficult to invest, further dampening economic growth.

In this way, inflation can trigger a vicious circle of falling output and rising prices. Inflationary expectations can also undermine the effectiveness of the monetary policy. Because the historical onset of stagflation represents the death of the leading economic theories of that time, economists have proposed several theories to explain how stagflation develops or how to reframe the parameters of existing theories to explain it.

Oil Prices

In the 1970s, stagflation occurred largely due to the oil price shock that hit the industrialised world. This was caused by the Yom Kippur war between Israel and its Arab neighbours, leading to the Arab oil embargo and a decision by the Organization of Petroleum Exporting Countries (OPEC) to raise prices.

However, the renewed rise in oil prices in recent years reflects far more than the actions of OPEC. Geopolitical tensions have been escalating in the Middle East, including the conflict in Syria and the resurgence of Iraq under the leadership of Prime Minister Nouri al-Maliki.

The rise of the Islamic State of Iraq and Syria (ISIS) has also recently threatened the territorial integrity of Iraq. The group has captured large swathes of Syria and Iraq and has taken control of several major cities.

In addition to oil-producing countries, additional geopolitical tensions are affecting the price of oil in other regions of the world. In March 2014, Russia mobilised troops on its border with Ukraine, indicating a possibility of further military conflict between these countries and the West. The conflict in Ukraine is not just affecting the price of oil, but also Russian assets, as there are fears of a new Cold War. The Russian stock market has dropped nearly 40% since the start of the year, and the country's currency has fallen 40% since January.

The effect of all this is that the price of oil is over $100 a barrel. The higher price level is expected to last throughout the summer and significantly impact the second half of the year. The higher oil price is likely to squeeze household budgets, hurting consumption and growth. Meanwhile, it will drive up inflation.

Bad Economic Policies

Another approach states that the combination of stagnation and inflation is the outcome of poor economic policy. Stagflation is thought to be caused by harsh control of markets, products, and labour in an otherwise inflationary environment.

The Fed's policy of quantitative easing (QE) is also viewed as a cause of stagflation. QE is enacted when central banks buy assets from financial institutions with the goal of increasing the money supply to stimulate the economy. Although QE has not been introduced in Russia, the policy is one of the main reasons for the sharp increase in inflation in the United States. The Federal Reserve's buying of assets is viewed as inflationary.

Gold Standard

Some economists argue that stagflation resulted when the Bretton Woods system collapsed. The system centred on the gold standard, which defined the value of currencies in terms of gold.

When countries pegged their currencies to the gold standard, they were unable to adjust monetary policy, which resulted in balanced budgets and low inflation. However, a lack of flexibility in monetary policy also resulted in a lower rate of economic growth. A potential solution to this dilemma was to allow a country to have a limited amount of inflation in exchange for higher economic growth.

This would create the "optimum" exchange rate for a country. However, the gold standard prevented monetary policy from being adjusted, making it impossible to maintain the optimal exchange rate. As the optimal exchange rate changed, so did the price of gold, resulting in the breakdown of the gold standard. While the Bretton Woods system was in place, it, too, prevented countries from adjusting their monetary policy. This led to the general price inflation and stagnation in growth.

Stagflation Versus Inflation

The combination of high inflation and low growth is called stagflation. Stagflation is viewed as a severe problem that can lead to a self-reinforcing spiral of falling GDP and rising inflation and, by definition, is classified as a negative economic state.

Stagflation and inflation are both economic states in which the price level is rising. However, stagflation is characterised by both an increase in the general price level and a decline in output and employment.

Inflation is typically characterised by rising price levels resulting from too much money chasing too few goods. This can be caused by a combination of excess labour and capital, a decline in the supply of goods relative to the demand for those goods, and other causes. Inflation can also result from a decline in the supply of goods, but this is less common.

The primary way to understand stagflation is to examine how the factors that drive inflation and drive growth interact. Inflation occurs when the supply of goods and services falls short of the demand for those goods and services. When the supply of goods and services rises short of demand, the result is deflation, a negative inflation rate.

Stagflation is characterised by three main factors:

  • An increase in demand for goods and services
  • A decrease in the supply of goods and services
  • An increase in the cost of goods and services

In a typical inflationary situation, demand for goods and services rises faster than the supply of goods and services, causing the cost of goods and services to rise. By definition, stagflation consists of two factors that are working against each other, causing the price of goods and services to rise and output and employment to fall.

How Does Stagflation Affect Emerging Market Currencies?

Stagflation is one of the worst things that can happen to a currency. It gives central banks very little leeway since they cannot raise interest rates sufficiently to offset increasing prices. When prices grow disproportionately to interest rates, the domestic currency's value falls. This, in turn, diminishes customers' purchasing power. As a result, stagflation is frequently seen negatively by foreign exchange markets.

While developed-market central banks have the option of adjusting their policy mix to deal with stagflation, emerging-market central bankers lack such an escape hatch. They are left to face the prospect of higher inflation and a deceleration in economic growth. Emerging-market central bankers are faced with the difficult challenge of balancing their inflation and growth objectives. If they opt to control price growth, they will end up with a lower growth rate, which can be particularly troublesome for countries where growth has been the main driver of economic expansion in recent years.

In the face of stagflation, emerging-market central bankers might be forced to raise interest rates to contain inflation. If this occurs, their economies will slow down, which will subsequently lead to a decline in their currency values.

Inflation is also likely to rise in many emerging markets. As demand for domestic currency increases, commodity-rich countries that peg their currencies to the U.S. dollar could be forced to intervene in the foreign exchange market to prevent their currencies from appreciating.

However, when emerging markets intervene, they cause their currencies to depreciate. Since their currencies tend to be linked to their commodity prices, their economies are susceptible to the effects of stagflation. One of the reasons for this is that the prices of oil, commodities, and other emerging market exports often tend to be volatile.

The Importance of Diversification

The importance of diversification is well-known for investors. It's also vital for central bankers, given the potential for stagflation. Central banks from emerging markets, in particular, find themselves in a tricky situation. If they decide to fight inflation rather than growth, they risk slowing down their economies. If they choose growth, they risk higher inflation.

Diversification is one strategy they can adopt to hedge their bets. Investing in various currencies, including the U.S. dollar, the euro, the yen, and the pound, can serve as an important barrier against stagflation. Investors should consider hedging their portfolios against this sort of risk by investing in a mix of international assets.

How Businesses Can Combat the Effects of Stagflation

As businesses in both emerging and developed markets face stagflation, the importance of currency protection is becoming clearer. One way companies are hedging against the instability is through forward contracts. Forward contracts enable companies to gain price protection against currency fluctuations.

The contract requires that the company exchange the price of a currency at the current spot rate for a future price. It is a type of hedging instrument that is frequently used by those who operate in emerging markets.

For example, if a company that gets paid in U.S. dollars for its exports is afraid that its local currency will appreciate, it can use a forward contract to protect itself. It will exchange the price of the local currency at the current spot rate at the time of the contract for a future price. If the price of the local currency appreciates, the company will be compensated with the difference. If the local currency depreciates, the company will cover the difference.

While forward contracts protect businesses against the price fluctuations associated with stagflation, they also can improve a company's cash flow in the long run.

Companies that use forward contracts can earn interest from the cash they receive from the foreign currency at the current spot rate. This interest income can be used to help cover the cost of the currency that a company needs to exchange for the forward contract.

Conclusion

Companies will likely continue to be challenged with stagflation for the foreseeable future. Central banks from major economies such as the United States, China and the Eurozone are expected to continue their plans of quantitative easing once the current economic recovery period is over. Although this is bad news for speculative investors, it may be just the right thing to do for those who are looking to safeguard their assets.

Bound is a specialist foreign exchange hedging firm that offers currency protection for businesses.

We help companies that are at risk of losing money to changes in the exchange rate to protect themselves against these losses.

By using the services that Bound provides, UK companies of all sizes are able to conduct business in foreign currencies with complete certainty about the exchange rates that they will receive. Subscribe to our newsletter or watch a demo of our product today!

Share on :
Linkedin icon

Related Blogs