Bird's-eye view of emerging markets in the global currency wars


Sid Verma
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The multi-year investment bet: meet the emerging markets whose exchange rates need to strengthen or weaken, or where domestic demand needs to cool down amid overheating risks.

One of the chief gripes among financial market players against Brazil’s combative stance over the raging currency wars is the fact domestic policy calculations have contributed to FX appreciation, principally the government’s loose fiscal policy.

This fiscal stance, in Brazil and Colombia, has, in turn, kept inflation-targeting monetary policy tighter, and, thereby, attracted greater capital flows. Logically, therefore, nations that cry foul over FX appreciation – blaming G7 stimulus for currency-strengthening capital inflows – can, to some extent, dodge the bullet if they reduce spending. That’s the logic, at least according to the IMF and other hawkish observers.

 Brazil FM Guido Mantega; source: Reuters
The trouble with this argument is its ideological upshot. Even though there are few proponents of laissez-fair global capital mobility these days, for many, these trade-offs are contentious. Should emerging markets, faced with uncomfortably strong currencies, be forced to slash spending on pro-poor and long-term output-positive sectors such as health and education, or deal with the currency challenge through FX intervention and capital controls?

In short, what’s more tolerable: large-scale government spending, higher interest rates, strong currencies and besieged exporters. Or: lower spending – thereby, the prospect of a smaller social safety net – and, with it, a looser monetary policy and a potentially buoyant manufacturing sector? Meanwhile, to boost growth, according to the latter policy framework, the government should boost supply-side reform.

There are many generalizations in this policy bind but, in any case, these challenges, in the recent debate at least, have lacked an overarching macro-economic framework.

Enter Capital Economics. Adapting the Swan diagram – developed by the Australian academic Trevor Swan in the 1950s – the research shop has offered a fresh perspective on global currency wars. In short, using the diagram below, the report concludes that “macro imbalances in those EMs that have been most vocal about currency strength (mainly in Latin America) are as much a result of excess domestic demand as they are misaligned currencies. By contrast, those countries that do require a weaker exchange rate to redress macro imbalances (mainly in Emerging Europe) have been notably quiet on the issue of currency wars.”

The framework is pretty simple and advances two notions. Firstly, it echoes conventional macroeconomic theory that flexible exchange rates in emerging markets help to deliver macroeconomic balance by acting as a shock absorber by reducing costly adjustment in domestic wages and nominal prices. In short, when domestic demand falls, a weaker real effective exchange rate (REER) boosts exports and maintains full employment. Likewise, when “domestic demand picks up, a stronger REER is needed to choke off demand and prevent inflation from accelerating”. These two forces also help to balance the current account positions in emerging markets.

Secondly, the framework confirms what is known as the ‘impossible trinity’: the hypothesis that it’s impossible to manage exchange rates, control inflation and allow the free movement of capital at the same time. In short, something has to give and flexible exchange rate regimes, which, after delivering hard-fought stability after successive crises in emerging markets in the late 90s and early 00s, are under siege as importers/exporters lash out against ostensibly G7-induced volatility.

So without further ado, here is the Swan diagram, in Capital Economics's words: 

Table 1 allocates EMs to the various quadrants of the Swan diagram based on the latest data. The countries that lie in quadrant B (and thus need a weaker REER) include Egypt and South Africa (whose currencies have already weakened in recent months) as well as several economies in Emerging Europe. It is notable, however, that policymakers in these countries have yet to raise concerns over the strength of their exchange rates.

By contrast, those countries that have been more vocal in expressing concerns about currency strength (mainly in Latin America) typically have a current account deficit and are operating at full employment (i.e. are in quadrant C on Chart 1).

Countries in quadrant D require a stronger REER to restore macroeconomic balance and tend to lie in Asia. We are particularly bullish on the Philippine peso. Finally, Hungary and Slovakia, which are the only two countries in quadrant E, need to reflate domestic demand to restore macro balance.

In short, this diagram is a useful tool to understanding the policy bind in emerging markets, though, granted, most developing economies, en route to economic convergence, tend to run current account deficits .

- Quadrant C highlights overheating risks and how, though weaker currencies might help, at its core, weaker demand is needed. What's more, in many of these economies, a looser fiscal policy is needed just when it is, politically speaking, the least-desirable outcome amid growth concerns.

- If Quadrant C is accurate, then domestic demand is unlikely to power growth in the coming years because it is coming from a high base in recent years, cf. Brazil.

- Ukraine and Egypt clearly face a structural over-valuation FX challenge and are wisely seeking to talk up their currencies, while Mexico and Thailand are in the enviable position of boasting balanced economies.

The above charts are destined to shape the prospects of emerging markets in the coming years.