With 2022 approaching the halfway mark, markets may feel that the topic of Covid has subsided after the peaks and dips of the pandemic over the course of two years. But as always, new challenges emerge and pave the way for even more potential vicissitudes.
Inflation is the flavor of the year as economies falter in the wake of the pandemic, with central banks tightening monetary policy to manage declines in their currencies and limit rising inflation. This topic presents a particular challenge to emerging market economies. So is the US dollar, which is becoming increasingly stronger.
All previous emerging market repercussions were associated with the strength of the dollar, and with the emergence of the need to avoid declines in currencies, central banks turned to tighten their monetary policies. This has resulted in the World Bank forecasting only a 4.6% expansion in emerging economies this year, compared to a previous forecast of 6.3%. Meanwhile, the International Monetary Fund expects inflation to be 9.5% in emerging markets this year, or about 3.6% higher than expected in January.
Why does a strong dollar lead to a struggle for emerging market economies?
First, a strong dollar often begins to dampen the growth of global trade, as it is the world’s billing currency and has the greatest purchasing power. This means that when the value of the dollar rises, the value of other currencies essentially falls, making the world poorer and less able to engage in trade.
It also makes countries with dollar-denominated debt less creditworthy, as it makes it more difficult for them to buy US currency to manage their debt. Moreover, it is likely to be less favorable to China.
This can lead to a crippling effect for emerging market countries due to the supply chains and the demand for associated goods. Finally, a strong dollar is also likely to cause inflationary upward pressures for emerging markets as they usually buy their raw materials in US dollars.
Commodity appreciation – who reaps the benefits?
Another complication for emerging markets is the simultaneous rise in commodity prices, which is likely to continue for some time given the current economic landscape.
Emerging markets are experiencing the lagging effects of higher oil prices, higher food prices, and higher import prices from currency depreciation. With the increase in the demand for products, the demand for the materials used for their production increases, which leads to the rise in the prices of basic commodities.
Commodities are also closely related to the dynamics of supply and demand, and compared to other inflation protection assets such as TIPS (Treasury Inflation Protected Securities) they tend to offer higher returns.
Higher commodity prices tend to hurt emerging markets, but others will benefit. Commodities are an important source of exports and revenue for many emerging economies, and more than half of the world’s poor live in commodity-exporting countries. Dependence on commodities is particularly high for oil exporters such as Brazil, Mexico and Russia, and on mineral and agricultural exporters such as South Africa and Chile.
Commodity prices undergo recurring cycles, and on average, from peak to peak, the cycles last approximately six years.
For commodities with heavy industry use, such as copper and aluminum, prices remain in the same phase of the cycle for 80% of the time.
According to the World Bank Group’s main report from January 2022, this synchronization was statistically reflected in a common factor that accounts for, on average, approximately 15-25% of energy and mineral price volatility, but only 2-10% of price volatility for agricultural commodities and fertilizers.
As the chart below shows, commodity prices rebounded in 2021, partially correcting for the sharp decline during the Covid 2020 pandemic, and that rally continued into 2022.
Global trade, supply disruptions, and climate-related events are areas that can amplify commodity price movements and their role in economic activity. Therefore, an understanding of the movement in commodity prices can help in managing financial stability and fiscal and monetary policies.
By taking inflation out of the mix, commodities and their associated currencies still need to be managed
The changing value of a currency against the dollar can have a significant impact. Whether the country is the importer or the exporter will determine the beneficial or counterproductive outcome of currency movements.
For example, China is the largest participant in the global copper market; Therefore, the exchange rate between the renminbi and the US dollar plays a major role in this trade. China is the largest producer of refined copper, but a lot of ore and concentrates are imported. Since the copper market is traded primarily in dollars, how the value of the Chinese renminbi (RMB) changes against the US dollar greatly affects the economy and trade outcomes.
The volatility in the USD/RMB (CNH) pair is causing divergence in the copper markets’ prices in the US dollar and the Chinese national currency. However, CME Group offers futures contracts on the Chinese renminbi, which can be used to manage this foreign exchange exposure through hedging.
The United States is the largest producer and exporter of corn, and Mexico is the largest importer of the United States. Therefore, as the importer, Mexico is more exposed to exchange rate risk between the US dollar and the Mexican peso (USD/MXN).
If the dollar rises, Mexican importers will be negatively affected as corn becomes more expensive, but vice versa if the dollar weakens. CME Group offers both futures and options contracts on the Mexican peso that can be used to manage this type of foreign exchange exposure, while the CME corn futures contracts are the global standard for this market.
Similarly, the South African rand is linked to precious metal prices, with South Africa as the source. And although their price is often correlated (for example, higher metal prices can often lead to a stronger rand), there are still exchange rate risks between the rand and the US dollar, as metals are primarily priced in dollars.
CME Group offers both futures and options contracts on the South African Rand which can be used to manage this type of foreign exchange exposure.
Commodity and derivative exchanges around the world offer the possibility to trade and manage risk for both currencies and commodities. CME Group offers a variety of derivative contracts to manage these risks together or as separate products.
As shown, the trend of the dollar significantly affects emerging market currencies and exchange rate risks, especially for imports and exports. While the dollar remains strong compared to other currencies, it will continue to retain purchasing power and make it more expensive for emerging economies to engage in trade.
High inflation is also adding to the struggle for emerging markets, with central banks turning to tighter monetary policy to help drive prices higher. Inflation is likely to remain in focus.
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