Emerging markets corporates: Main beneficiaries of a weaker USD

The US dollar (USD) has risen relentlessly since the financial crisis, especially against emerging market (EM) currencies. However, this inexorable climb has been losing steam for some time now. It is becoming tangible that the weaker dollar and a simultaneous strengthening of local currencies will take pressure off emerging markets. In particular, the USD-denominated debt burden of EM governments and companies is becoming more sustainable and their refinancing costs are receding. This will lead to improved credit ratings in the medium term and should bring about further inflows of capital and stimulate growth. In simplistic terms, foreign capital gives an added boost to production; in addition, there is plenty of upside potential given that many emerging market currencies have been structurally undervalued for years –thus triggering a self-reinforcing feedback loop.

Years of a strong dollar had a serious negative impact on many emerging markets. Direct investment in EM plummeted. At the same time, the interest charges incurred by sovereign and corporate USD borrowers rose. Inflation in emerging markets also went up as foreign imports became more expensive. To support their local currencies, many central banks therefore resorted to a restrictive interest rate and foreign exchange policy – thus exhausting a good deal of their foreign exchange and gold reserves. Despite regular interventions, many EM currencies lost value due to the fact that the growth differential between emerging and developed markets was too small to attract investment at that time.

The US central bank has always taken the lead in the past. Record interest rates and a strong USD once again attracted capital flows last year. US equities rose, which in turn increased the demand for dollars. Even interest rate-sensitive technology shares – having benefited more than most from the years of low interest rates – went unpunished and proved very popular, despite being enormously overvalued. Periods of uncertainty, risk aversion and extreme volatility additionally prompted investors to flee to the safe haven of liquid US sovereign bonds. All these factors invigorated the USD, and the unchecked rally continued.

Advantage for commodity-exporting countries
However, we are now seeing a new overall situation emerge. Massive levels of debt, falling demand for US securities and a weaker US economy are presenting the US central bank with a tough dilemma. US inflation has levelled off at a rather high level and the dynamic has now eased somewhat. The EUR/USD exchange rate has hit the key technical mark of 1.10 and this holds potential for a consolidation or slight correction in the near term. However, the temporary recovery gives investors the chance to offload further dollar risk.

We should not forget that EM central banks – unlike their developed market peers – took decisive action early on and raised interest rates markedly to curb inflationary pressure. Therefore, they are now starting from a better place than their DM counterparts.

Generally speaking, currency fluctuations in EM are of utmost importance for investors. They can trigger significant feedback loops on market sentiment and risk appetite. Inflows into the asset class can have very rapid and positive effects on a country’s finances or EM companies’ balance sheets. Accordingly, this should affect possible returns in the near term.

Over the years, emerging markets found various ways to hedge against the effects of fluctuations in the dollar. Some countries have pegged their currencies to the dollar or set a narrow band for currency fluctuations, while others have tried to reduce their dependency on the dollar, with many local companies increasingly refinancing in their respective local currencies. A weaker USD and therefore stronger EM local currencies would greatly reduce the burden on the public finances and on company balance sheets in some respects. In particular, commodity exporters, such as Brazil, Columbia, Mexico, Indonesia, China and South Africa – as well as the related companies – could be disproportionate beneficiaries of a weaker USD. In general, EM corporates are currently offering attractive risk premia. The risk/reward ratio for EM investors is therefore fair and – given the rise in interest rates globally – this asset class offers a high carry.