For many emerging economies, 2014 has gotten off to a grim start. Concern over the Chinese economy’s marked slowdown and the Argentine peso’s steep slide against the US dollar has triggered heavy selling pressure on an array of emerging-market currencies. But the current volatility does not portend sustained weaker growth in emerging economies as a whole. Differentiation is needed, and that is what financial markets are now doing.
The scale of the battering varies widely from country to country. For example, the problems currently dogging Argentina are anything but a surprise. On the contrary, they are the near-inevitable result of years of policy mismanagement that has spawned high inflation, a badly overvalued currency, and massive erosion of foreign reserves.
By contrast, the currencies of Central and Eastern Europe’s emerging markets have remained relatively stable. For example, thanks to Poland’s robust economic performance, the złoty has essentially maintained its exchange rate against the euro, slipping 2.2% since the start of the year (as of the beginning of February). The Hungarian forint lost slightly more than 5% against the single currency over the same period, but this is less sharp than in the past, when the country’s macroeconomic problems made the exchange rate far more sensitive to shifts in market sentiment.
The stabilization of the eurozone economy and the reduction of imbalances have helped to improve the growth outlook for Central and Eastern European countries. Furthermore, most of these countries have made progress taming their own imbalances. By contrast, the Russian ruble has continued its lengthy nosedive this year, tumbling by more than 5.5% against the euro by the beginning of February. The reasons are mainly homegrown: a poor investment climate, heavy capital outflows, and a shriveling current-account surplus.
A look at Latin America also reveals wide regional differences. The Argentine peso, the region’s main culprit, has plummeted by 19% this year against the US dollar. In Brazil, the real’s losses in 2014 have been comparatively mild, but this comes on the heels of the hefty depreciation last year. Capital is also heading for the exit in Mexico and Chile.
The region’s reliance on commodities is fraying nerves. If Chinese economic growth turns out to be weaker than expected, commodity prices and exports are likely to fall, undermining Latin American countries’ growth. However, with global industrial-production indicators climbing since the second half of 2013, pointing especially to improvements in the advanced economies, gloomy forecasts for commodity markets seem off the mark.
So far, Asian currency losses have been limited. The South Korean won has experienced the largest slide, with a loss of 3% from the start of the year to the beginning of February (though this comes in the wake of a protracted upward trend). The Indian and Indonesian currencies have been weathering the storm quite well, but both fell steeply last year. The Indian rupee, burdened by a chronic current-account deficit, stubbornly high inflation, and a sharp slowdown in growth, lost 11% year on year by the end of 2013.
Paradoxically, China, the country currently under the brightest spotlight, is the only major emerging economy whose currency rose slightly against the US dollar in January. Given the enormous challenges that China faces – from rebalancing its growth model to addressing credit and real-estate bubbles – this is remarkable. Chinese officials are poised to tighten monetary policy and impose regulatory measures to curb debt momentum, which is bound to mean sacrificing short-term economic growth in order to put growth back on a stable footing. Evidently, the markets think the authorities are up to the task.
Turkey, a country whose enormous growth potential is marred by major imbalances, has not been so fortunate. The Turkish lira is being pilloried, sliding more than 7% against the euro in January and 24% since the middle of last year. But Turkey’s vulnerability to an abrupt shift in financial markets from risk-on to risk-off was foreseeable. Yawning current-account deficits (funded mainly by short-term capital inflows), domestic political uncertainty, and past episodes of unorthodox monetary policy have all undermined investor confidence in recent months. As in China, the necessary adjustment processes will weigh on short-term growth, though the medium- and long-term outlook is positive.
The financial markets are evidently punishing the currencies of countries that, due to macroeconomic imbalances or political instability, are susceptible to external shocks of any kind. Indeed, some players fear that the spiral of depreciation, higher inflation, and rising interest rates could broaden out into a full-scale crisis of confidence.
But, while the further withdrawal of capital cannot be ruled out, not all investors swim with the tide. With prices in the affected countries at a much more favorable level, confidence-building policy measures could quickly encourage forward-looking investors to test the water.
Broadly speaking, devaluations can help boost competitiveness and reduce external deficits. But in the short term, they can exacerbate economic problems by inciting higher wage demands, fueling inflationary pressure, and boosting external-financing costs.
In these circumstances, monetary policy must perform a balancing act. In order to counter a devaluation-fueled rise in domestic inflation, the central bank needs to raise key interest rates – but without throttling the economy. Policymakers are more likely to succeed to the extent that domestic reforms address macroeconomic imbalances and other obstacles to long-term growth.
Michael Heise is Chief Economist at SE.