How is China’s Bad News Affecting Emerging Market Currencies

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Why the Fed’s interest rate move matters

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The Federal Reserve, the US central bank, has, as expected, cut its main interest rates at a meeting in Washington on Wednesday.

The aim is to stimulate the US economy and get inflation closer to the Fed’s target of 2%. But it will have ramifications far beyond US shores.

Why does Fed policy matter for the rest of the world?

There are two general answers.

One is that the US economy’s performance is important for the rest of us. If the Fed gets it wrong the US could end up underperforming, which would be bad news for many other countries.

The second point is that Fed policy can have an impact through financial markets by affecting currency exchange rates, interest rates and international flows of investment money.

What difference does the health of the US economy make for the rest of us?

For most countries on the planet, the US is an important export market – for many, the largest of all.

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If the US has a recession, it will buy less stuff from abroad than it would have if growth had been maintained. Its immediate neighbours, Canada and Mexico, are particularly exposed. For both, more than three-quarters of their exports go to the US.

The UK is also at some risk from economic storms in the US, although not to the extent of Canada and Mexico. The US is the largest single country export destination for the UK, though the UK exports much more to the countries of the EU taken together. The US accounts for about 13% of UK exports.

What is the Fed’s role in keeping the economy healthy?

The Federal Reserve has a mandate from the US Congress to promote maximum employment and stable prices.

It raises interest rates if inflation is too high, or it thinks it is heading that way. It cuts rates if it thinks there is a danger of economic growth slowing too much or inflation being too low.

Rate cuts make it more attractive for business to borrow to invest and households to borrow to spend. The Fed is perhaps the key player in trying to prevent a recession and promoting a recovery if there is a downturn.

The Fed has started reducing interest rates in an attempt to maintain solid economic growth in the US.

Growth has slowed, though there does not appear to be an imminent danger of the economy actually contracting. That said, there have been some warning signs in the financial markets that often do signal a recession is not that far away.

The rest of the world keeps an eye on how well the Fed is managing to keep that balance between growth and inflation, since a healthy US economy reduces the risk of the rest of the world catching a dose of economic slowdown.

What impact does the Fed have on currency markets?

Cuts in interest rates in any country tend to make its currency lose value against others.

That is because lower interest rates mean there is less money to be made by investing in that country’s assets, since they’re yielding less interest. Primarily that means government bonds.

If investors are less keen to buy, for example US government bonds, there is less demand for the currency needed to buy them. So the currency concerned, the dollar in this case, tends to lose value.

Currency movements affect how competitive countries’ exports are. If US rates are cut and the dollar weakens, American exports become cheaper, and imports to the US from elsewhere go up in price. That can have a knock on impact on the price of goods on shop shelves, in other words inflation.

But for other countries importing goods priced in dollars, the impact can be to reduce inflation. When the dollar is weaker it costs other countries less in their domestic currency to buy dollar-priced goods. And that’s not just American exports, lots of commodities including oil are priced in dollars.

What about the impact on international investment flows?

When an economy as large as the US changes its interest rates, it is possible for the subsequent movement of investment funds to be disruptive.

There was an episode in 2020 when the Fed started to consider reducing its quantitative easing programme. That programme involved creating new money to buy financial assets such as government bonds. Reducing QE was in some ways akin to raising interest rates.

The plan was to “taper” the quantitative easing, and the result for emerging economies such as India and Indonesia came to be known as the “taper tantrum”.

Large amounts of money left emerging market economies, and there were concerns at the time that it might even lead to a new financial crisis in those countries. In the event, that did not happen.

This time, because interest rates are likely to be cut, it is more likely that money will go into emerging economies. That can sometimes lead to financial instability (or unsustainable bubbles). That is not an immediate concern now, but it is a reason why governments around the world need to keep a careful eye on what happens in the US.

What Are Emerging Markets? Characteristics and List

What Are Emerging Markets?

Emerging markets (or EME, for the emerging market economy) are economies of countries that are in the progress of becoming a developed country and typically are moving toward mixed or free markets. Emerging market economies often have lower per capita income than developed countries, and often have liquidity in equity markets, are instituting regulatory bodies and exchanges, and see rapid growth.

The term “emerging market economy” was first used in 1981 by Antoine W. Van Agtmael of the International Finance Corporation of the World Bank.

Emerging markets have played a large role in stimulating global economic growth, especially after the 1997 currency crisis – which necessitated an overhaul of many emerging market economies to become more sophisticated.

Around 80% of the world’s economy is comprised of emerging markets – including some of the largest countries in the world like China, India and Russia.

As of 2020, China and India made over $32.6 trillion worth of economic output – while also making up 40% of all labor force and population on the planet. And, according to World Bank data last year, China is expected to represent over 35% of global gross domestic product (GDP) growth from 2020.

But, why are large countries like China or Russia are considered emerging markets?

Definition of Emerging Markets

Emerging market countries are those that are striving to become advanced countries and are generally on a more economically disciplined track to become more sophisticated – including increased fiscal transparency, focus on production, developing regulatory bodies and exchanges, and acceptance of outside investment.

Although some countries like China and India have high production and industry, other factors like low per capita income or a heavy focus on exports qualify even large countries as emerging markets.

Characteristics of Emerging Markets

There are several aspects that characterize an emerging market.

As a preliminary base, emerging markets typically have a lower-to-middle per capita income. This means that the per capita income of the countries’ economies is generally lower than other more developed countries like the U.S. or similar countries. For example, the per capita income (PCI) of India in 2020 is said to be around Rs 1,12,835, or around $1,606.54 USD. The PCI is used as one indicator of how prosperous a country is. However, because emerging markets are striving to become more industrialized quickly, they often have higher growth per year than the most developed countries like the U.S. or U.K.

Additionally, emerging markets typically have some sort of regulatory body as well as a market exchange for investment and a common currency. For example, China has a common currency – the Chinese Yuan, as well as a regulatory body, The China Securities Regulatory Commission.

While emerging markets often have a higher rate of growth compared to developed countries, they are often plagued by higher sociopolitical instability and volatility. Many emerging markets have military unease and social upheaval that create high volatility. In fact, volatility is a major facet of emerging markets – with things like natural disasters or price shocks affecting growth and the economy. For countries like Thailand or Sudan, droughts or tsunamis drastically impact markets, as both are more traditional economies with a focus on agriculture or natural resources.

Still, emerging markets are often vulnerable to swings in commodities (like oil or food goods) or other currencies – especially the USD. In fact, 2008 subsidizing of corn ethanol products in the U.S. caused some riots in emerging markets due to rapidly increasing food and oil prices. Vulnerability to similar changes is due to how emerging markets often do not have as much control over such industries (with the possible exception of countries like China and India, which are among the top producers in the world).

However, emerging markets generally have lower industrial production compared to advanced economies like the U.S., but typically have liquidity in local debt or equity markets.

But unlike developed countries like the U.S., emerging markets often have immature capital markets that pose some risk to investors. Because their markets are still developing, emerging market economies don’t often have a lot of information about traded companies on their exchanges, and selling debt (like bonds) is often more challenging.

However, outside investors who are able to research these companies are often rewarded with higher-than-normal returns, making emerging markets a risky yet possibly lucrative investment. This is often due to the fact that emerging markets are typically export-heavy.

Emerging Markets List

There is no universal consensus on exactly which countries qualify as emerging markets. However, there are several different lists that have become generally accepted for establishing emerging market countries.

According to the Morgan Stanley Capital International Emerging Market Index, 24 developing countries qualify as emerging markets – including Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. The index follows the market caps of the companies on the countries’ stock markets.

Additionally, the International Monetary Fund (IMF) has a similar list of 23 countries, although there are some discrepancies in the list compared to the MSCI list.

Among the IMF and the MSCI, the S&P, Dow Jones and Russell all have lists of emerging markets that follow similar strains, although with some variation.

However, despite some differences, all of the institutions are at liberty to change their lists, either promoting or demoting an emerging market.

Emerging Markets and the International Monetary Fund

The IMF, as an international organization designed to help stabilize global economies, has long monitored emerging markets.

Pakistan is the latest country to seek out an IMF bailout, although several countries over the years have received bailouts from the fund.

Recently, the IMF released a study wherein it summarized that while emerging markets should survive the recent market volatility, they would face a new crisis of a massive draining of capital out of the countries. In their Financial Stability Report, the IMF delineated several emerging markets especially at risk for contractions, including Argentina.

According to IMF’s managing director, Christine Lagarde, in a speech earlier this year, the building pressure on emerging markets “could lead to market corrections, sharp exchange-rate movements and further weakening of capital flows.”

Additionally, according to recent findings, the IMF released charts examining the global economy – which showed that the past year has seen slowed industrial production and trade since 2020, increased trade policy uncertainty, and increased strain on emerging markets over the strengthening of the USD.

Emerging Markets News

The U.S. market has been in a major meltdown in recent weeks – and it’s affecting emerging markets as well.

Rising tensions and volatility over recent Fed rate increases has spilled over into uncertainty abroad, as emerging markets’ stocks have taken similar hits.

Additionally, with the recent economic boom coming from U.S.’s corner of the globe, emerging market economies have found themselves bleeding investors – signaling something akin to a market meltdown in some emerging markets, according to The Guardian earlier this year.

“More pain seems to be ahead for emerging markets as the combination of global trade tensions, prospects of higher U.S. interest rates and overall market uncertainty haunt investor attraction,” Lukman Otunuga, research analyst at currency dealer FXTM, told The Guardian in September.

To make matters worse, emerging markets are baiting their breath prefacing several events that Bloomberg delineated this week as deciding factors in the recent market turmoil, including “Egypt’s interest rate decision, Brazil’s budget balance and Argentina’s economic activity index.”

Investing in Emerging Markets

Still, some investors remain bullish on emerging markets and their profit potential.

Because emerging markets are so focused on growth (and, on average, have a higher growth rate per year than developed countries like the U.S.), they often deliver higher return potential and higher capital gains.

If you’re looking to invest in emerging markets, TheStreet designated the 10 best-emerging markets ETFs for 2020 – including iShares MSCI Russia (ERUS) – Get Report , WisdomTree Middle East Dividend Fd (GULF) – Get Report and iShares Emerging Markets Dividend (DVYE) – Get Report .

While investing in emerging markets can help diversify and boost your portfolio due to how motivated emerging countries are to becoming advanced through commodities and production, they remain relatively risky investments because of their volatility and frequent political or economic instability.

Contagion fear: emerging markets’ currency crises spook investors far and wide. How will Asia fare?

Patrik Schowitz says that as bad as the news has been for emerging markets, particularly Turkey, Argentina and South Africa, there’s little risk of a total meltdown among Asia’s emerging economies, where fundamentals look sound

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