Why is a Weak US Dollar Good For Emerging Markets?

Recently, there have been a few views that the USD’s value is sliding down against other currencies with current account deficits and insufficient domestic savings. Four “channels of dollar transmission” point to such a devaluation financially benefiting emerging market economies.

According to Bloomberg, after reaching a peak against other currencies in March 2020, the dollar fell by almost 15 percent until the beginning of December 2021. Asset portfolio managers have been assuming "short" positions against the dollar, betting on its fall ahead. Analysts expected the dollar to fall against the euro, the yen, and the Chinese yuan—which it did by 2021.

The dollar rose almost 10 percent in the first quarter of 2020, reflecting investors’ search for a haven in cash or short-term U.S. bonds. In the following months, the mood improved, and people’s appetite for risk.

Today, however, many analysts foresee that U.S. current account deficits and insufficient domestic savings will make the dollar less valuable over time.

Before financial experts shift into survival mode via currency protection, a recent Quarterly Report by the Bank for International Settlements (BIS) shows that strong financial conditions and sustained credit expansion favour growth on the basic side of emerging economies this year. The Report's authors—Hofmann and Park—compare this to a 1 percent change in the dollar's value against a broad basket of other currencies: it reduces growth by 0.3 percent. A shock in the opposite direction, leading to a dollar devaluation, would boost their fortunes.

Let’s explore what the authors called four “dollar transmission channels” to see how the dollar’s waning strength leads to the growth of the global economy.

Channel 1: Increased Risk Appetite for Investors

When investors lose their risk appetite, they look for a place to keep their money safe while waiting for the economy to recover. The dollar is that place—its value, measured by its exchange rate, goes up.

Meanwhile, capital outflows and worsening financial conditions at the origin of the crisis are observed. The value of risky assets like stocks and commodities goes down. When the dollar rises in value, economic activity also drops. So while it seems safer to revert to currency protection when USD values drop, the opposite is quite true: investors and financial experts can capitalise on this downtrend.

Channel 2: Reduced Global Credit Liabilities

In 2020, the BIS reported a considerable mismatch between currencies on the sides of liabilities and assets in global credit. Then, when the dollar fell, balance sheets with liabilities in other currencies that had dropped compared to their assets became stronger. This increase in strength led to an increase in credit supply because of more risk assessment. Trade finance was significantly impacted. Connecting this to the first channel, currencies gain buying power and result in the financially-minded leaning towards trading over currency protection.

Channel 3: Improved Political Economies

On the other hand, changes in the risk conditions of the entire bond market for government bonds in a local currency affect investors who carry securities from different countries in their portfolios. The same BIS study demonstrated changes in the foreign exchange value of an emerging market economy’s (EME) currency against a broad set of other currencies that play a more significant role than changes in its currency value against the dollar.

Channel 4: Foreign Trade

A dollar's devaluation will affect its value relative to other national currencies, making it more or less competitive in export markets. Of course, if other currencies are also devalued, it won’t matter much. That doesn’t happen too often. Prices for goods and services are determined in several ways, but one is by listing the prices in U.S. dollars. If a currency devalues relative to the dollar, it will take more of that local currency to pay for a given product.

Thus, if the USD’s value is low, local currencies increase in value, citizens and investors are more likely to buy, and economic activity grows.

These Channels’ Connection to EMEs

These four channels matter the most for EMEs through the following connections:

• First, the dollar’s value significantly affects trade and investment. For example, Mexico's auto industry in the United States would take a hit if the dollar went up too much.
  
  

• Second, borrowing money in dollars rather than in local currency is risky because it leaves investors vulnerable to exchange rate fluctuations. Because Mexico has a large amount of its debt in dollars, it will be hit especially hard by its value.
  
  

• Third, since international trade invoicing is more common in emerging economies than in developed economies, it will affect them more.
  
  

• Finally, the financial channels matter because they make changes in the value of the dollar trickle through to other parts of their economy. In some cases, like Brazil’s, that transmission happens right away; in others (like Mexico’s), it takes longer for financial conditions to change.

Samer Shousha from the Federal Reserve Board previously mentioned these four points and four connections, where he stated thusly in his published work back in 2019:

“… dollar-denominated credit plays a central role in global trade, which has generated a growing integration between emerging markets (EMs) and international supply chains. In addition, the dominant currency paradigm in global trade has weakened due to EMs receiving greater international demand. Finally, research has shown that as long as financial vulnerabilities exist, EMs with higher exposure to dollar-denominated credit have an increased probability of experiencing currency crises during a foreign exchange market crisis.”

As the research clearly shows, the more the USD appreciates, the more investors may tend toward currency protection.

How a Weak USD May Benefit Asian EMEs

China is the biggest Cinderella story of the Asian economy at the moment, but that doesn’t mean the U.S. is irrelevant to other Asian nations. Fiscal and monetary policy in the U.S. has significant effects on other Asian economies. Given the upbeat outlook for China, Asian emerging markets (EM Asia) could benefit from a more robust Chinese renminbi.

While a stronger renminbi could be considered a haven for investors and will benefit accordingly, there are concerns about the fiscal health of China. Rightly so, the Chinese have spent heavily on its economy in recent years to help it grow.

The total budgetary stimulus could be 40 percent higher than similar interventions elsewhere, assuming a fourth stimulus package is eventually passed. This is starting to point toward a more upbeat outlook for the renminbi and a more bearish view of the U.S. dollar – which could be positive for emerging Asian markets. Here are some potential outcomes:

• The actual positive yield offered by emerging Asian markets could result in international bond investors pouring money into these economies from a stance of currency protection, even as regional central banks in Asia have also cut rates to support domestic economies following the COVID-19 pandemic.
  
  

• More robust Asian equity markets could help improve Asian economies’ balance of payment position, attracting capital inflows and reducing the foreign debt burden, particularly in countries that need foreign capital to finance current account deficits (the gap between imports and exports) and whose private sectors have borrowed in U.S. dollars.
  
  

Over the past decade, emerging Asian markets have generally increased their foreign debt stocks, particularly in local currency-denominated debt. A weaker U.S. dollar would reduce the foreign-denominated debt stock and related interest payments.

• A weaker U.S. dollar means that the currency’s value decreases compared to another’s. The dollar might become more vulnerable if the EMs they trade with grow faster than those of the developed markets (DMs).
  
  

The EMs might also see faster growth if global trade progresses more quickly in the future. All of these factors would make the dollar weaker. We anticipate that the weakening of the U.S. dollar will likely coincide with a modest recovery in worldwide economic growth and a modest recovery in global trade.

The dollar is not the only driver of Asian economies’ success. For example, Northeast Asian countries like China and South Korea have contained mainly the pandemic and are forecast to grow at a robust annual pace over the next two years.

Meanwhile, in west Asian countries like Saudi Arabia and Turkey, economic weakness was exacerbated by the rapid spread of Covid-19.

Nevertheless, we maintain our view that Northeast Asian economies like China and South Korea are leading the region. They have managed to get Covid-19 under control while their domestic economies have recovered and resumed regular operation without excessive stimulus support—either fiscal or monetary.

How All These Impact Global Investments

Emerging market equities tend to outperform those in developed markets during U.S. dollar weakness, and EM Asia is no exception. The U.S. Dollar Index (DXY) tracks the dollar's strength against the currencies of the U.S.’ most significant trading partners. Traditionally, when the dollar has weakened, it has been an indicator that EM stocks have performed better relative to U.S. stocks.

Although it has recently weakened, this indicator still supports our view that in periods when the U.S. dollar is weak, EM stocks do better, and EM credit spreads tighten.

Despite the fact this negative correlation has weakened in recent years, this trend supports our view that EM currencies versus the U.S. dollar reflect both the global business cycle and the growth fundamentals of the EM world.

During periods of U.S. dollar weakness, we would also expect EM credit spreads to tighten. Historical data suggest that EM credit spreads are inversely correlated with EM currency strengths and commodity prices. We recommend that investors increase exposure to good-quality corporate credit in Asia, away from currency protection.

What does this mean globally? Although this may seem good news for developing markets, it also has negative repercussions. During low U.S. interest rates, many emerging market governments and corporations may take advantage of a weaker dollar value to borrow money cheaply and at more favourable exchange rates to finance domestic growth initiatives and budgetary needs. At the same time, capital flows towards emerging markets seeking higher investment returns.

There are several reasons to be bullish on emerging markets. The currencies of these countries have been more robust than the US dollar, making their stocks cheaper. Earnings for these companies are projected to increase next year, as are profits for companies in developed countries, thanks to the rollout of new vaccines.

As people in developed countries catch up with vaccinations, vaccine stocks will be more popular. Lastly, as COVID vaccines are rolled out in developing countries and become more widespread, optimism will grow in their economy's ability to return to full capacity.

How All These Impact Your Investments

There are three examples to consider: the worst-case, the likely case, and the best-case scenarios:

• Worst-Case: If your portfolio is made up of companies that rely heavily on imported materials, energy, or commodities, the purchasing power of the U.S. dollar declines along with its value. Thus, it will cost U.S manufacturers more to buy their materials, putting pressure on their profit margins and bottom lines.
  
  

• Likely Case: If your portfolio comprises a diverse collection of companies that operate worldwide and sell to many different markets, then a falling U.S. dollar will affect them in many ways, but the result should be balanced. You’ll win some and lose some, as they say.
  
  

• Best-Case: If your portfolio is based on companies that make U.S. manufactured goods and sell them overseas, you have better chances of gaining wins than losses. Companies that rely on multiple income streams tend to do better than those that rely on a single one, as they are exposed to less risk if one part of the business goes south.
  
  

Thus, buying companies that have all their business overseas, or concentrate heavily on foreign sales, will benefit from a higher dollar. When they convert foreign cash back into U.S. dollars, these companies get more U.S. dollars for their money, and foreign money is what their products bring in.

These companies are based worldwide, and a strong dollar makes US-manufactured goods more competitive in international markets. By diversifying your portfolio with these companies, you’ll avoid the risk of a lower dollar.

Conclusion

While the U.S. dollar is the most recognisable currency globally, financial and trading decisions should not solely revolve around it. Evidence proves a myopic devotion to one currency results in more disadvantages than benefits. Thus, it is best to capitalise on the countries connected to its value and invest in those currencies for holistic currency protection and appreciation.

Get better currency protection today from Bound, the automated hedging platform that helps businesses and traders maximise their Forex trading! Learn more about the FX market right now!