As currency markets face chaos, old-school solutions will be key

1. Yield advantage: US

US yields are now higher than they were at the beginning of 2024, and are expected to stay higher for much longer. Comparable yields of other countries have not risen to the same extent. This places most countries—both advanced and emerging—at a yield disadvantage. A widening yield gap puts pressure on their currencies to weaken. Hence, a wide swathe of developed nations’ currencies have also slumped against the dollar; emerging economies face a double whammy with risk-aversion also coming into play.

Countries are trying to combat the fall in different ways. India has intervened to support the rupee, Malaysia has urged businesses to repatriate and convert export earnings to boost the ringgit, and Indonesia unexpectedly raised the policy rate to stabilize the rupiah. The Bank of Japan has warned of possible rate hikes, and South Korea issued a joint statement with Japan and the US expressing serious concern over the strong dollar.

2. Oil price tail risk

Oil prices have been edgy since the oil producers’ cartel announced production cuts in March. However, it was the sudden direct conflict between Israel and Iran in April that pushed the price of Brent crude above $90 per barrel. Prices have moderated since then, but a rise in oil price remains a tail risk that no country can afford to ignore.

For oil importers such as India, China and South Korea, the impact is direct and obvious. Higher crude prices imply higher import bills and a worsening trade deficit, which weaken the currency. But even oil exporters (Malaysia, US) are affected by second-round effects: rising pump prices reduce household purchasing power and push up prices of goods and sectors in which crude is an input. A return of inflation is a potential nightmare for countries going to polls this year (India, US), or for those struggling to restore growth to pre-pandemic levels (China, Indonesia).

3. China exposure

Currencies of countries with large China exposure have been beaten down relatively more due to China’s uncertain economic recovery. This group of mainly Asian high-performers had benefited hugely from China’s steady double-digit growth in the pre-pandemic years. Markets are justifiably concerned about their future growth prospects with China’s growth slowing to about 5%.

The nature of China-dependence varies across nations. South Korea has invested in semiconductor factories in China. Japan recently restricted exports of advanced chip-making equipment to China, yet China accounts for about 20% of its exports. Both Taiwan and Malaysia saw slowing exports in 2023; over 70% of the decline in Taiwan was attributed to a drop in exports to China. In contrast, Brazil, which exports a diverse basket of agricultural necessities and commodities, may be less vulnerable to a Chinese slowdown, and Australian businesses have already found customers for their exports in other geographies. Nonetheless, both countries have seen their exchange rates hammered in line with their China-exposed peers.

4. Fiscal prudence

Countries with significant amounts of dollar debt are most at risk when the US dollar strengthens, because a weaker currency makes it harder to repay debt commitments. In addition, large populist or non-productive government spending weakens the exchange rate, even if it is funded by domestic debt. That’s because such fiscal expansion diverts government revenues away from productive expenditure. Thus the overall debt score card has an impact on currencies, particularly for emerging markets.

Markets prefer fiscal prudence: a weaker fiscal stance and the resulting government borrowing pushes the currency down. For instance, the Brazilian real dropped sharply in April when the government proposed new rules to loosen budget deficit targets. In Indonesia, when the incoming government announced a free school lunch scheme that would increase borrowings, it led to huge foreign outflows in the bond market that pushed the rupiah to a four-year low.

5. Economic growth

Markets like economic growth, especially if it is strong, steady and sustainable. High-growth economies attract international capital. For capital-scarce emerging economies, these inflows fund investments and projects that generate jobs and incomes, further enhancing growth and attracting more capital flows in a virtuous cycle. The downside is that the inflow of dollars puts pressure on the currency to appreciate. Recollect how the Indian rupee strengthened almost each year during 2003-04 to 2007-08, riding on five years of booming growth: we have neither seen such growth nor such appreciation since then.

This connection operates in reverse too: currencies of economies with uncertain growth outlook tend to depreciate. For example, China has continually weakened its yuan in recent weeks under pressure from a stronger dollar and weak domestic growth. The lesson is that economies seeking exchange rate stability should focus on growing at a steady clip. Growth is a panacea for most emerging market ills.

The author is an independent writer on economics and finance.