We expect volatility in emerging markets (EM) currencies to increase.
Last June, Bank for International Settlements (BIS) highlighted that USD-denominated debt to non-bank borrowers (most, if not all, of whom are in EM countries) surged to USD9.2trillion (BIS 84th Annual Report, June 2014). Three months later, BIS warned that currency mismatches arising from these offshore USD-denominated debt is a “potential source of vulnerability” (BIS Quarterly Review, September 2014).
Their overriding concern is a strengthening US dollar increases the risk of financial distress for USD-strapped borrowers. A stronger US dollar increases the cost of financing in local currency terms. Many of the EM economies are heavily reliant on commodities such as crude oil, iron ore and coal for export revenues. The recent double- digit slump in commodity prices has literally brought the growth of many of these economies to a standstill. To underscore the concerns raised by BIS, Indian central bank governor Raghuram Rajan warned on February 4th 2015, that “borrowing in dollars is like playing with Russian roulette”, telling companies to hedge more or find themselves at the “wrong end”.
Not everyone is on the same page as the BIS and Raghuram Rajan. Some argue that the US dollar strength is not an issue. According to Barclays’ and Goldman Sachs’ analysts polled by Bloomberg (April 2th, 2015), the largest of these non-bank borrowers are generally not affected by the rising US dollar as they have (i) US dollar revenues to match their debt obligations and/or (ii) already hedged their US dollar debt. There are some companies that may suffer from local currency declines and have issues servicing their debt. However, both Barclays and Goldman Sachs do not expect such potential individual default cases to rock the entire boat and trigger a debt crisis in the EM economies.
Our view is we cannot be complacent – any financial stress in the EM economies will rock the US dollar debt boat. Historically, investors adopt a panic-driven sell-first and not a cherry-picking mentality when exiting their EM investments during a crisis. As such, investors with EM assets or holding significant EM currency balances should be nimble and err on the side of caution by either exiting totally or at the very least, hedging their local currency exposures to protect the value of their EM investments.