02 November 2022
It is fair to say that since the financial crisis of 2008, there have been many challenges for developed, emerging and frontier markets. You only need to look at the currency crisis in the UK to see that even some of the larger global economies are struggling. While some frontier markets wereset to gain emerging market status in the short to medium term, they may need to wait until the dollar falls in relative terms. So why are frontier markets at the beck and call of the US dollar?
There are several frontier markets in the APAC region, including Vietnam, Bangladesh, Pakistan and Sri Lanka. However, in a reflection of the challenging times of recent years, Pakistan was recently downgraded from emerging market status to frontier market. This is a consequence of the struggling economy and an inability to finance government debt. This then prompts the question, how does a strong dollar impact frontier markets?
From a distance, inflationary pressures in Europe and the US, together with the Far East, would appear to have similar roots. Or do they?
The enormous fiscal package used to support individuals, businesses and the government during the Covid pandemic led to inflationary pressure in the US. Yes, the energy crisis has had an impact but not to the extent seen in Europe. Consequently, the increase in US interest rates by the US Federal Reserve is directly impacting inflation, subduing demand.
In Europe, inflation is being fed by the energy crisis more than traditional inflationary pressures. While there are still conventional inflationary pressures, much of these can be connected in some shape or form to the increase in energy prices. In this scenario, the European Central Bank and the Bank of England know that increasing interest rates will not have the same effect as in the US. Only when energy prices come down will we see an actual reduction in inflation, which could be some way off.
Many frontier markets feed off the dollar's strength (and safe haven status), with a significant percentage of national debt denominated in dollars. Selling dollar-denominated bonds in frontier markets creates a direct link with the US dollar while raising funds. So, as the US continues to increase interest rates to fight inflation, not as much of an issue in the APAC region, this prompts a relative decline in frontier market currencies.
To pay dollar-denominated interest on debt, emerging and frontier market countries will need to buy "expensive" dollars on the foreign exchange or run down their dollar reserves. Under traditional circumstances, emerging and frontier market countries would increase their interest rates. However, while this may help maintain short term relative parity with the dollar, it would decimate the national economies and create even more problems.
Many emerging and frontier markets are praying for dollar weakness in the short to medium term, to reduce growing debt repayment problems. This appears unlikely in the immediate future, with suggestions that US base rates could rise even further in the short term. While emerging and frontier marketswill feel the pressure, countries such as Vietnam appear well-positioned to weather the storm. Those countries with inherent financial weakness prior to the pandemic will be even more exposed as the dollar strengthens.Back to News