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Lessons Learned: Emerging Markets and the
U.S. Dollar 

Andrew Hencic, Senior Economist | Andrew.Hencic@td.com

Date Published: November 9, 2022

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Highlights

  • The U.S. dollar has appreciated sharply this year. However, much of its strength has been vis-à-vis advanced market currencies, rather than those of emerging markets (EM). 
  • Portfolio flows to EMs are down sharply so far in 2022, but the decline is more modest than prior periods of financial stress. 
  • Pockets of fragility exist but many EMs have entered this rate hiking cycle in relatively solid position and should be able to withstand the coming challenges.
Chart 1 shows the year-over-year percentage change in the nominal trade-weighted U.S. dollar. It also shows the growth rates for the U.S. dollar against its advanced economy trading partners and emerging market trading partners. The chart shows that the dollar has appreciated most against the basket of advanced economy currencies.

An appreciating U.S. dollar and a rapidly tightening Fed conjure up memories of sovereign debt troubles and balance of payment crises in emerging markets (EMs). Adding to the worries are results from the IMFs recent Global Stress Test suggesting that up to 29% of EM banks could breach key capital ratios in the event of a severely adverse economic scenario1. It's always dangerous territory to say "it's different this time", but major EMs have evolved their safeguards and are not displaying the stress-points of past cycles - or, at least, not yet. This is partially reflected by much of the dollar's appreciation being vis-à-vis advanced market economies, rather than their emerging market counterparts (Chart 1)2. While pockets of fragility exist, many EMs have entered this rate hiking cycle in relatively solid position and should be able to withstand the coming challenges. 

A hawkish Fed and global economic concerns have driven a flight to safety out of risk assets and into the U.S. dollar. This has lifted the dollar 12.6% year-over-year (on a trade weighted basis). However, it has appreciated 17.6% against advanced economies and only 8.1% against emerging markets. 

Chart 2 shows portfolio flows for emerging markets broken down by debt and equity flows going back to 2005. The chart shows that total flows through the first nine months of 2022 are negative (indicating outflows) and that much of the weakness is coming from outflows from equities. This is a steep decline relative to the strong inflows in 2021.

That said, portfolio flows to EMs (closely tied to asset prices) are down sharply this year (Chart 2). In the first nine months of 2022, emerging markets portfolio outflows have totaled $13 billion. In the grand scheme of things, this is modest when benchmarked to other periods of financial stress. For instance, in the nine months to July 2008, EMs experienced a $115 billion exit in funds. However, this year's pattern is a sharp reversal in investor sentiment when compared to the $332 billion in net inflows over the same period last year. Indeed, even after excluding China from the EM basket, net flows are down nearly 75% – from $190 billion this time last year to roughly $48 billion this year. Current circumstances are reminiscent of the toxic combination that precipitated EM sovereign debt crises' in the past. 

Most outflows have, unsurprisingly, been concentrated in equity markets. Excluding China, this has totaled roughly $27 billion through September, compared to outflows of $15 billion through the first nine months of 2021. Despite China's well-publicized struggles, equity outflows have totaled only $2 billion this year. 

In contrast, debt markets in most EMs continue to attract capital, albeit at a much reduced pace from last year. Through September, total debt portfolio flows are down 94% (to $17 billion) from the same period last year. This is largely attributed to one EM – China – where outflows have totaled $59 billion. As investors move money to the relative safety of the U.S. dollar, emerging markets are feeling the brunt. 

Yet, despite capital moving out of emerging market investments, their currencies are holding up better against the U.S. dollar than their advanced economy counterparts (Chart 1). This reflects, in part, the fact that many EMs are entering this rate hiking cycle with healthy reserves and a hawkish monetary policy stance. For instance, among some of the United States' largest trading partners, most ended 2021 with reserve balances well in excess of the IMF's Adequate Reserves Metric (Table 1). 

Table 1: Reserve Adequacy

*2022 Year-to-Date
Source: IIF, IMF, TD Economics.
  2018 2019 2020 2021 2022**
Major EMs Ex. China 154 154 168 169 141
Argentina 122 72 68 71 66
Brazil 166 147 164 162 133
Chile 91 86 84 111 77
Colombia 130 136 144 139 124
Indonesia 116 115 125 126 106
India 144 162 193 200 159
Israel 267 264 278 279 233
Korea 112 108 99 99 85
Malaysia 114 115 119 122 98
Mexico 116 114 127 128 121
Philippines 189 201 237 230 194
Russia 295 304 358 339 290
Thailand 209 216 248 244 193
China 89 85 75 69 58

Creating a buffer heading into this year's perfect storm of monetary tightening ahead of the flight to safety has proven prescient for many EMs. As the Fed's aggressive tightening cycle got underway, countries were in a position to deploy reserve buffers to stem their currency's slide against the dollar (Chart 3). South Korea, India, Chile, and Brazil are standouts here, selling reserves through the first nine months of the year. Beyond active operations, additional drawdowns have been the result of the surge in commodity prices that has left many countries, and particularly those reliant on energy imports, running down their foreign currency savings (Chart 4). Yet, despite the challenges, most countries maintain reserves levels comfortably above the recommended IMF thresholds. The notable exceptions are South Korea, Chile, and Malaysia who have run down their balances over the past year (Table 1).

Chart 3 shows the reserve operations for the set of emerging market economies that are included in the Fed's trade weighted dollar measure. Of the countries with substantial negative values in 2022 are Brazil, Chile, Indonesia, India, South Korea, Malaysia, Philippines and Thailand. Chart 4 is a scatterplot of the year-on-year percent change in reserves relative against the net oil exports for each country. The chart shows a negative relationship between the change in reserve balances and net imports of oil. This indicates that the rise in energy prices relative to other goods and services has meant many emerging markets have had to draw on reserves. Singapore is in the bottom right quadrant (indicating the largest drawdowns and most import dependence). Saudi Arabia is in the upper right quadrant reflecting positive reserve growth and net oil exports

Indeed, for most EMs under study here it would take drawdowns similar to the worst of the Asian Financial Crisis (1997-1998), or the Global Financial Crisis (2008-2009), before reserve balances deteriorated below recommended levels. As a case study, applying the most severe annual drawdowns from those episodes exacerbates conditions in countries already falling short of the IMFs metric and results in Indonesia and Brazil being added to the list of risky countries. They key takeaway here is that most EMs are starting the slowdown in a position of relative strength. That is not to say that there are no risks, but the size of the shock would have to be substantial to have a large, destabilizing effect. 

Ample reserves form one bulwark against currency depreciations, but monetary policy also plays an important role. As inflation picked up in 2021 a number of EM central banks started their rate hiking cycles well before their advanced economy counterparts (Chart 5). Of the 19 countries included in the Fed's trade weighted dollar basket, 7 started raising rates before March 2022 (the month the Fed raised rates the first time), 7 after, and 3 moved the same month. The monetary policy tightening at a time the Fed was signaling no rate changes built a cushion to help sustain capital inflows through 2021. China and Russia are the outliers from the group. The former is dealing with domestic economic issues, while the latter is cutting rates after abruptly raising them to stem capital outflows after invading Ukraine. 

Chart 5 shows the change in official policy rates for emerging market economies for the time periods between February 2021 and February 2022, and between March 2022 and October 2022. The chart shows Argentina, Brazil, Chile, Colombia, Korea, Mexico, and Singapore raised key policy rates in advance of the Fed's March 2022 rate hikes.

Looking forward, there is a daunting stock of debt that needs to be serviced. EMs borrowed heavily to offset the effects of the pandemic, pushing debt relative to the size of their economies to record highs. Yet, even here there is a silver lining. 

The credit-to-GDP gap – the difference between the current credit-to-GDP ratio and the historic trend – gives an indication of how far domestic sector are beyond historic borrowing patterns. As of the second quarter, South Korea and Saudi Arabia are the only major emerging markets where both household and non-financial corporate debt are above their respective long-term trends (Chart 6). Moreover, in the case of Saudi Arabia, this is not all that worrisome given the strong economic growth projected this year as energy prices remain elevated. 

What is worrisome is the volume of U.S. dollar debt due in the coming years. Across EMs, roughly 660 billion in U.S. dollar denominated debt is maturing in 2023, and another 630 billion in 2024 (Chart 7). Faced with a stronger U.S. dollar, and significantly higher interest rates, the cost of debt has risen sharply. Thus, the upcoming need to roll over the obligations could produce a significant drag on economic activity beginning in 2023. Knowing that Chile has already drawn reserves down below recommended levels (Table 1), the fact that 75% of its maturing debt in 2023 is U.S. denominated adds to the concern (Chart 8). Indeed, the IMF has already approved an $18.5 billion flexible credit line for Chile "to provide insurance against adverse scenarios".3 It's possible that other countries may follow this approach in preventative measures.  

Moreover, slowing demand in the U.S. and China are putting additional strain on coffers as replenishing hard currency stockpiles becomes more difficult. Those economies most reliant on exports to these economic powerhouses are facing a steep slowdown in demand for goods and services (Chart 9). 

Chart 6 shows the credit-to-GDP gaps for emerging market countries for the household and non-financial corporate sectors. The charts shows that for most emerging markets countries, the credit-to-GDP gaps are negative, indicating ratios below long-term trends. The exceptions are the non-financial sectors in Korea, Saudi Arabia, Singapore and Thailand, and the household sectors in China and Hong Kong. Chart 7 shows the stock of U.S. dollar denominated debt maturing between 2021 and 2026. The chart shows that the largest volume of debt matures in 2023 (at nearly $700 billion). The next highest reading is for 2024. The chart also shows that China's debts make up a substantial proportion of the debt.
Chart 8 shows the share of maturing debt that is U.S. dollar denominated for a set of emerging market countries for the years 2022, 2023 and 2024. The chart shows that Chile, Colombia and Saudi Arabia have more than 60% of their maturing debt in 2023 denominated in U.S. dollars. A distant fourth is Indonesia at just under 32%. The average for emerging markets (other than China) is 18% in 2023 Chart 9 plots countries based on the share of their exports that go to China or the U.S. For countries close to the origin of the chart, they are relatively insulated to the changes in demand conditions in the heavyweights. For those further away, changes in economic conditions in China and the U.S. present a risk to economic growth. Among those are Mexico, Chile, Colombia, Vietnam, Malaysia, Philippines, South Korea, and Brazil.

Countries are also facing domestic challenges. Real incomes are contracting as import prices rise faster than export prices, creating a classic terms of trade shock. Additionally, as we highlighted in recent work, food expenditures make up a larger share of household expenditures in emerging economies. This year's shock to food prices, and an uncertain outlook for 2023 amid prohibitive fertilizer costs, will leave little income left over for households to support domestic demand. Slowing economic activity at home amid softening external demand will add strain to government coffers heading into a year with substantial debt rolling over. 

That is why, despite having weathered the initial storm admirably, the outlook is mixed. For most countries, ongoing outflows and falling reserve balances should be manageable through next year. The most present risk over the next 12-to-24 months is that inflation in the U.S. proves to be even more persistent than expected and the Fed further extends its rate hiking cycle. In that event, even the solid buffers countries have developed may begin to dry up. 

What this makes clear is that there is no "one-sized-fits-all" narrative for emerging market economies. For the most part, large EMs have proven to be resilient to the shocks thus far in 2022, but an increasingly challenging global outlook in 2023 means those rainy-day savings will still be needed.  

End Notes

  1. International Monetary Fund (Oct. 2022) "Global Financial Stability Report": https://www.imf.org/en/Publications/GFSR/Issues/2022/10/11/global-financial-stability-report-october-2022 
  2. Emerging markets included in the trade-weighted dollar basket are Argentina, Brazil, China, Chile, Colombia, Hong Kong, Indonesia, India, Israel, South Korea, Malaysia, Mexico, Philippines, Russia, Saudi Arabia, Singapore, Taiwan, Thailand, and Vietnam.  
  3. IMF (Aug. 2022) "IMF Executive Board Approves Two-Year US$18.5 Billion Flexible Credit Line for Chile":  https://www.imf.org/en/News/Articles/2022/08/29/pr22294-chile-imf-executive-board-approves-two-year-flexible-credit-line-for-chile
     

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