LONDON (Reuters) - With the dollar and U.S. Treasury yields marching higher, the latest emerging market firestorm risks plunging these countries into a self-perpetuating cycle of falling currencies, higher U.S. yields, a stronger dollar and mounting pressure on their FX reserves.
It goes something like this: rising dollar-denominated debt refinancing costs hit emerging currencies, triggering capital outflows, prompting central bank intervention by selling U.S. Treasuries, which pushes yields and the dollar even higher.
There is an inverse relationship between the dollar and global FX reserves, a large chunk of which consists of U.S. Treasury notes and bonds.
A falling dollar is generally associated with looser global financial conditions, increased cross-border capital flows, strong growth and rising trade surpluses across emerging markets. Those surpluses are used to build up FX reserves.
But a rising dollar has the opposite effect, and the pace of reserve accumulation slows or even reverses.
(For a graphic showing Global FX reserves vs dollar, click here: reut.rs/2K9qyKT)
In some emerging market hot spots, that cycle may be getting underway. Between March 1 and April 27, Argentina sold $8 billion of reserves to stop a run on the peso. That’s nearly 15 percent of its total FX reserves.
Since April 27, the peso has slumped to a record low, the central bank has hiked interest rates to 40 pct and President Mauricio Macri has confirmed that Argentina is seeking a financing deal with the International Monetary Fund.
Argentina may be an extreme case, but no emerging country can afford to be complacent. According to the Institute of International Finance, more than $900 billion of emerging market bonds come due this year.
Indonesia’s FX reserves fell by $7.1 billion to $124.9 billion between February and April as the central bank tried to support the rupiah. But the rupiah still lost 5 pct of its value in that three-month period.
Turkey’s reserves are down nearly $3 billion since February.
The sums involved in these countries are small when set against global FX reserves of over $11 trillion, and the IIF expects emerging market central banks to accumulate over $220 billion of FX reserves this year. But that will be less than 2017 and will probably be even less should the dollar and U.S. yields continue rising.
Global FX reserves were $11.42 trillion at the end of last year, according to the IMF, mostly held by emerging nations. A decade ago they stood at $6.7 trillion, and at the turn of the millennium they were $1.78 trillion.
But that growth hasn’t been uninterrupted. They were nudging $12 trillion in early 2014, just before the dollar embarked on a two-and-a-half-year, 30 percent rally. China, the world’s largest currency reserves holder with over $3 trillion, saw its stockpile fall by $1 trillion.
After recording its biggest annual fall last year since 2003, the dollar is bouncing back. It’s up nearly 5 percent since mid-April, and the 10-year U.S. yield is above 3 percent.
With the Fed almost alone among major central banks raising interest rates, both could continue heading higher, although the 10-year yield is struggling right now to rise much above 3 percent.
It’s generally assumed that FX reserves are buffers built up over years of relative good economic and financial times by countries, mainly emerging markets, to help see them through the bad times. But according to the IIF, emerging market central banks draw down their reserves only reluctantly.
“Emerging markets are more willing to stem (domestic currency) appreciation through reserve accumulation but are averse to selling reserves during depreciation episodes,” the IIF wrote in a note last week.
“This means that official intervention is unlikely to provide much of a buffer when depreciation pressure sets in, as is the case across emerging markets currently,” it said.
Yet they might have to dip into their reserves. In a speech in Zurich this week, Federal Reserve Chair Jerome Powell suggested the Fed has no intention of straying from its path of tighter policy just to dig emerging markets out of a hole.
Ultimately, by signaling it won’t tighten policy as much or as quickly as markets expect, only the Fed can really slow or reverse the rise in the dollar and U.S. yields to ease the strain on emerging currencies.
But Powell said the influence of Fed policy on global financial conditions “should not be overstated.” Post-crisis stimulus from the Fed has had a “relatively limited role” in the surge of emerging market inflows in recent years, he added.
Emerging markets’ reluctance to draw down reserves could be put to the test, though. As the IIF describes it, the stronger dollar and rising U.S. yields represents a “paradigm shift” for investors.
It’s a shift that threatens to slow capital flows into emerging market this year and trigger that vicious spiral.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever, graphic by Ritvik Carvalho, editing by Larry King