As the world contends with yet another week of the Coronavirus outbreak, the negative economic effects are growing ever more clear and the data is far from ideal. In my post from last week (link) I mentioned U.S. unemployment claims as a good leading indicator of just how bad things are in the real economy. At present, some 24.4 million U.S. residents have filed for unemployment benefits so far in April, a truly staggering sum that erases away a decade of job gains in the years following the Financial Crisis. Things look little better out of China despite the fact the state is further along in dealing with Covid-19. Gross Domestic Product, a measure of total economic output, contracted 6.8% in Q1 to mark the first such decline for the East-Asian state in more than 40 years and this reported handle was likely underestimated. Chinese retail sales, another key measure of growth, fell nearly 16% in March against year earlier levels, hardly a sign that things are quickly returning to normal and lending more evidence to the fact that economic recovery will be slow and difficult. Even British state officials provided forward guidance, predicting GDP could contract 13% in 2020, far surpassing anything previously seen.
Policymakers have stepped in to blunt the blow of such traumatic economic slowdowns, especially in large developed economies. Places like the United States, the United Kingdom and Germany have a relatively large amount of flexibility to undergo deficit spending to prop up demand in market segments that have seen a near elimination in normal consumption behavior. China, a large, high growth, semi-capitalist emerging market also enjoys such flexibility, albeit to a slightly lesser degree. But what about most other developing markets (also known as emerging markets)? That is, economies with average GDP per capita far below those of a developed country - places like South Africa, India, Brazil, Mexico and Russia? These countries face the prospect of long, deep economic downturns due to a limited ability to stimulate via fiscal or monetary policy.
At present, global stock markets appear to be undervaluing the risk of long-term output contractions in developing economies, which face dual constraints.
Limits on governmental ability to borrow money and stimulate domestic demand
Limits on central bank ability to purchase domestic debt to drive down interest rates and keep businesses solvent
Unlike governments with strong, stable currencies (EU trading bloc, United States, United Kingdom, Japan), public and private sectors in a developing economy are forced into "Dollarized debt obligations," or in simple terms, taking out loans in U.S. Dollars (or in some other major global currency). The reason for this is that many international investors are unwilling to make loans available in relatively less-stable, local, emerging market currencies. This presents sizeable risk exposure for the borrower (the emerging market).
Let's run through an example to illustrate the problem of Dollarized debt obligations. Assume the U.S. Dollar / South African Rand exchange rate decreases from 1 Dollar per Rand to 0.5 Dollars per Rand. This effectively means a single Rand is only able to purchase half as many U.S. Dollars compared to before the exchange rate fluctuation. Now, assume South Africa has U.S. 20 million in debt outstanding. Originally, this debt was worth Rand 20 million (remember the initial exchange rate was 1:1), but after the exchange rate change, this debt has increased to Rand 30 million (remember, a Rand only purchases 0.5 of a Dollar after the exchange rate change). In other words, a weakening emerging market currency equals an increase in outstanding debts denominated in Dollars. This puts strict constraints on the ability of developing economies to borrow further to reduce the negative economic impacts resulting from Covid-19.
Over the past two months, emerging market currencies have realized significant declines against the U.S. Dollar. As of April 10th, the Mexican Peso is down 24%, followed by that of the South African Rand (-21%), the Brazilian Real (-19%) and the Indian Rupee (-6%) against early-February levels. Note that April has so far shown slight improvements given measures taken out of the U.S. Federal Reserve, but these moves are far from erasing prior losses.
Emerging Market / U.S. Dollar Exchange Rate Change Relative to February 1, 2020
The chart above displays the loss in value, in percentage terms, of selected emerging market currencies against the U.S. Dollar since the beginning of February
What causes such currency weakness? In times of economic stress, international investors will pull investment from emerging markets and return to the Dollar. This has the effect of strengthening the Dollar, because of an increase in demand, at the expense of the developing market currency, which realizes an equally large decrease in demand.
Emerging market currency weakness also makes it harder to utilize monetary policy. That is, lowering interest rates and purchasing debt to stem job losses and stimulate investment. Think back to our Rand / Dollar example from before. When the Rand weakened, Dollar debts got more expensive. Similarly, imports from abroad, usually denominated in Dollars (or another major benchmark currency) also grow more expensive, pushing up prices in the developing economy and stoking inflation. This limits the flexibility of the Central Bank to lower interest rates and purchase debt, both actions which also have the effect of increasing inflation. Indeed, import price inflation can quickly get out of hand forcing the Central Bank to take actions that are anti-stimulative (raising interest rates and providing fewer loans), thus weakening further economies already battered from Covid-19.
There was a lot covered this week. I know that the concepts examined can be a bit difficult to grasp, but I felt it important to provide insights into the risks that emerging markets present to global growth in the months ahead. Right now, the market is undervaluing just how serious the threat might be. If anything, keep the following points in mind:
Developing market currencies have weakened considerably against the Dollar, limiting the ability of these governments to borrow money, lower interest rates and purchase debt from firms struggling to stay solvent
Existing debt obligations have become dramatically more expensive to finance. Payments on these debts have been eased for now, but much more will need to be done to improve developing economy access to affordable debt in the months ahead.
The International Monetary Fund could be seen as a possible savior, providing cheap loans to developing nations in need, but this will hinge on the support of U.S. lawmakers who have shown a limited willingness to help so far.
A lack of borrowing capability could severely worsen the public health crisis in many emerging markets already struggling with oversubscribed healthcare systems.