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EM Currency Crunch: What Does It Mean for U.S. Investors?

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar.

Emerging-markets currency volatility has been topping headlines in recent days and stoking memories of the late 1990s currency crisis.

Here to talk about what this means for U.S. investors and why is this happening, is Morningstar's Bob Johnson, our director of economic analysis.

Bob Johnson: Great to be here today.

Stipp: Let's talk about what's going on with emerging-markets currencies. There was news about Turkey recently; other countries have been in the news. What are the factors at work that are causing these problems with these currencies?

Johnson: The big headline news is that the U.S. Federal Reserve has begun tapering their bond purchases, and [those purchases] will probably come to an end by the end of the year. What's happened is that a lot of people, when rates were so low in the U.S., were investing in emerging markets and cash flowed into those markets that offered higher rates than the U.S.

Now, as the U.S. rates have come back up--the 10-year bond is up from 1.8% to 2.7%-2.8%, so a big change in interest rates--and there is more turmoil around the world, so there is kind of a flight to safety as well. People are pulling out of the emerging markets and buying U.S. bonds instead of emerging-markets bonds.

Stipp: What does that mean for those emerging-markets countries, if people are leaving their currency and coming to the U.S. currency?

Johnson: When they sell their bonds, then they translate that back into dollars. What that does is, it depresses the local currency because you are selling it, and it boosts the dollar because you are buying dollars. So, it begins to really have an effect on the currency. You mentioned Turkey. That was one where this has been an ongoing issue, and there are some other side issues--it's an election year and there is a corruption scandal going on Turkey right now. Their currency is down by about a third.

Stipp: What does that mean from an economic perspective, if your currency has lost a third of its value?

Johnson: The biggest impact is that things that you import into your country now cost about a third more than they used to.

Stipp: So, inflation…

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Johnson: You are going to have a potentially big inflation problem, and that's probably the biggest direct impact. … Inflation is one thing that consumers and voters really don't tolerate very well. So, it's something that really scares these emerging markets.

The second thing is, as any of these emerging markets have issued debt in currencies other than their own, it just became 30% more expensive to finance that debt, and that can be very painful.

Luckily, this time around more of the emerging markets have debt in their own currency, which they couldn't do in the early 1990s.

Stipp: We saw Turkey's central bank step up this week with a pretty dramatic intervention. What are central banks in countries that are facing these currency stresses doing? What are their options? What is the effect of their moves?

Johnson: So far the primary thing that they've all used is raising interest rates. I mentioned the U.S. rates had gone up, and made the U.S. much more competitive. And so now as they raise those rates in the emerging markets, people might say, I'll take a chance. I'll leave my money there.

For example, the rate now in Turkey went from 7% to something like 10%. Even though inflation is probably tracking around 6% in Turkey, that's a pretty good real return, if they don't see further currency losses. So you've got that situation now where I think raising the rates stops the currency from going down.

I mentioned Turkey's currency was down at one point as much as a third. Now in the last couple of days, as rumors and the actuality of the higher rates have come through, the currency is back up 10%. So it works.

The other thing they can do is currency controls--we won't even go there. But there are other alternatives that they have that obviously the markets really frown on.

Stipp: Do you feel that it's more likely that [these central banks will be] successful with these measures--that they have the credibility to do this in areas like Turkey where they need to--so that we won't see this expand into a full-blown crisis.

Johnson: What's happened so far is [central banks] have done it by the playbook as they are really supposed to: Their currencies get weak. They boost the internal rates. And we've seen that this week in India, in Turkey, and in Argentina. You've seen some bands move around in Russia and a couple of other emerging markets as well. That's the solution that you're supposed to do. The bad news with that solution is that by raising interest rates, sure it keeps the capital from flowing away, but high rates all of the sudden make the local economy slow down.

It also tends to depress inflation, which is good news, but it really slows the economy. For a long time, Turkey and Argentina had avoided raising rates because they were fearful of what it would do to their economy. They were already somewhat fragile; they were growing slower than they had been. So, they were not anxious to raise rates. Whether they'll have the guts to stick with these high rates for long enough will be another question.

Stipp: Certainly, there is a downside, even if their policies are effective, for their own economies. So we'll have to keep an eye on it.

Johnson: They may save the currency, but ruin their economy.

Stipp: We were talking before about the late '90s currency crisis, and you were saying there are some differences in how currencies are managed now versus then that might suggest that what happens here will play out differently than what we saw in the late '90s. What are some of the key things we should keep in mind as we're comparing these events?

Johnson: I think one thing that's different is that, as I mentioned, a lot of the emerging-market debt is no longer in U.S. dollars. It's in either other currencies or a local currency. So with that, you are going to have a little bit more flexibility. That will certainly make the impact a little bit different. Last time around, it was so much U.S.-dollar oriented.

Also back then, there was usually some type of fixed exchange rate regime in place, rather than the floating rates that we see today. At that time, it made it kind of lucrative for traders to go in and attack a currency that looked vulnerable, and then all of a sudden, the government would have to make one big swoop and devalue the currency 10%-20%. And that was really, really painful, and hard to avoid. And now with a more floating-oriented regime, I think that will be less so this time around.

Stipp: And some areas will be harder hit than others. It kind of varies country-by-country what the impact could be?

Johnson: Every emerging market is different. We talk about emerging-markets funds, but it's getting harder and harder to talk about them in one breath. Certainly China has taken a lot of the emerging-market flows they've gotten and invested it in infrastructure and actually made it very difficult to pull the money back out, because it's in a long-term investment. Versus countries like India, Indonesia, Turkey that use the extra borrowing to finance a trade deficit. So it has a very, very different impact.

China probably gets hurt if commodity prices go high, as one emerging market. But then you've got countries like Russia and South Africa that are beneficiaries of commodity prices being higher, or right now, being hurt by low commodity prices.

So you can't speak of them all in one voice anymore. Some of them have corruption problems, some of them have structural issues, and those issues are different, and the timing is all different in those markets today. It's not all for one, one for all anymore.

Stipp: Let's talk about the U.S. now. The Fed, as you mentioned at the top of this interview, kicked off this situation that we have now with the tapering program, with rates coming up in the U.S. Is what's happening in the emerging markets going to have a role in how the Fed decides to continue tapering, not taper so much. How might this play into their decision-making process?

Johnson: Theoretically, it could, and certainly some of the actions in the Federal Reserve in the 1990s were involved in the process. But for now, I think that they want the end the bond purchases by the end of the year. I think they're a little scared by this, but they are probably pleased to see the countries reacting and raising their rates. Today when we hear [from the Fed], I'm not expecting them to say no more tapering because of emerging markets. I don't think that's going to happen.

Stipp: From a U.S. dollar-based investor's perspective, what do some of these currency movements and changes in interest rates mean for corporations or for investors?

Johnson: Paradoxically, a strong U.S. dollar is not necessarily a good thing short-term for investors. Because what happens is, in the case of a corporation that made profits overseas, those profits now turn into fewer U.S. dollars with a weaker currency. So that certainly is not going to help returns.

People who invest in mutual funds that are in foreign markets and those currencies are now worth less, their stock holdings are worth less, just because the currency has gone down, even if the company they own in that country has done well. So the paradox is, a strong U.S. dollar is bad for investor returns in the short run anyway.

Stipp: Do you think that the probability of a contagion, a large, global type of issue, is probably on the lower side right now given that we have seen the central banks take action, and that action seems to be working so far?

Johnson: I think it's good that they've begun to take action. For a while they were stonewalling and saying they wouldn't do anything. Now that India, Argentina, and Turkey have begun to take action, I think that will work in our favor.

What's probably a little bit worse about all those countries raising their interest rates, that's going to slow all those economies, and that's going to mean less exports to those countries from the U.S., from Europe, and from other developed countries. So it's not all good news, but at least I think the contagion is probably not going to happen this time around, but I could be wrong.

Stipp: Bob, a lot of moving parts with this issue, but thanks for the explanation and giving us some insights on everything that's at work here in these currency markets today.

Johnson: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.