There is evidence many of the world’s leading economies may be slowing and the markets are reflecting those fears. We believe part of the pressure being exerted on the emerging markets is a function of US monetary policy. Let us explain:
An interest rate is the “price” of borrowing or lending money over time. When our Federal reserve intervenes in the US interest rate market, as they have for the past four plus years, they keep the “price” of borrowing and lending in the US artificially low. This in turn impacts the value of the dollar relative to other currencies. With low interest rates the dollar “weakens” as capital leaves (or doesn’t come at all) the US in search for higher interest rates in other parts of the world.
I order to understand what this has to do with Emerging Markets, we have to ask what happens to emerging markets when the dollar weakens? The dollars spent by US companies and households buys less foreign goods and services than before. On the other hand, foreigners find that they can now buy more US goods and services with their currency. Because of this change in exchange rates the US trade deficit, which measures the difference between total imports and total exports, begins to shrink.
This narrowing of the trade deficit impacts Emerging Markets in two different ways. First, if an emerging country’s currency appreciates against the dollar, then that country becomes a less competitive exporter, which hurts overall GDP. The second effect is more indirect but could be a pivotal factor in global GDP growth the next couple of years.
The dollar is still the world’s reserve currency. If a country wants to participate in the global trade market, they have to first convert their domestic currency into dollars. A large deficit economy such as the US usually has a balance-of-payment deficit as well. This simply means that in order to buy all of the goods and services it wants from around the world, the US needs to “export” dollars. For years the US had a growing trade deficit and thus growing balance-of-payment deficit. The amount of dollars the US was exporting grew almost every year until the financial crisis. Because of low interest rates the trend has changed and the US current account deficit has been narrowing and so the US has been exporting fewer and fewer dollars to the rest of the world.