Fear of Emerging Market Contagion and What to do About it

The Emerging Markets (EM) are going through a tough period. As an evidence for this, the Argentinian peso is currently near an all-time low despite the decision by the central bank to raise interest rates. The Turkish lira is also near an all-time low against the dollar and the South African rand is at the lowest YTD low. The Indian rupee is at an all-time low against the dollar. The same trend is happening among all EM currencies. The chart below shows the performance of some of these currencies.

The main issue with the EM countries is the Fed’s hawkishness. After the appointment of Jerome Powell, the Fed has continued with the gradual pace of interest rates hike. In September, it is expected to hike again and there are chances that another hike will happen in December. These rate hikes have led to a stronger dollar as shown below.

As the dollar has gotten expensive, these countries have struggled to honour their obligations. This is because most of the world’s debt is dollars but the countries receive the funds in local currencies. When it comes to paying back the funds, they pay them in dollars. This means that the countries pay more money than they borrowed.

The recent crisis in Argentina started when the Argentinian president asked the International Monetary Fund (IMF) to release the funds. In a two-minute televised speech – that followed 7 straight days of peso weakness – the president pressed the IMF to release the $50 billion it had promised. Instead of calming the market as expected, the currency started falling leading to a 60% interest rate hike by the central bank. Even that did not calm the markets as the peso continued to slide.

The Turkish crisis on the other hand started with the re-election of Recep Erdogan. During the election, he promised to ‘take over’ the central bank with the aim of reducing interest rates. This problem was accelerated with the sanctions and tariffs threats from the United States. This was associated with the continued detention of an American pastor.

As the crisis in the EM is increasing, it has led to heightened worries of contagion. This is because most of the investors of the EM are from the developed countries. As fear continues, these investors are likely to pull out their funds, which is likely to lead to more sell-off. The risk of contagion comes because the funds to bail out these countries might not be there. For example, the $50 billion rescue package by the IMF to Argentina has proven to be inadequate.

In addition to the EM, the frontier markets too are having a problem. The frontier markets include countries in Africa and Asia. Their problems is that they took a lot of credit from China, to fund some unnecessary projects. Experts believe that the toxic debt from China to the FM and EM countries too presents major risks. For example, two weeks ago, Malaysia announced that it would stop some of the projects being funded by China. This came after China took over an important port in Sri Lanka.

These risks are important for investors who buy securities and hold them for months and years. On the other hand, day traders are not concerned about the issues because they make money when the securities are moving in both sides. Still, the issues call for due diligence among the traders.

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