A challenge emerging markets have been facing consistently over the years is currency market volatility. Year after year, currencies are devalued in an attempt to boost economic growth but seem to have only served to worsen external debt problems.

Last year was particularly bad as we saw major declines in the Turkish lira, Argentine peso, and the Brazilian real, not to mention the complete collapse of the Venezuelan bolivar. This year has been a mixed situation; besides the 25% overnight decline in the Argentine peso, there has mostly been slow downward trends or pauses in currency volatility. Obviously, such remarkable moves are more aligned to specific risks surrounding particular countries.

Causes of EM currencies declining

There are many reasons emerging market currencies have been hit particularly hard over the past few years. One major point is that most of these countries have the opposite problem as those in the developed world - high inflation.

Inflation directly devalues a currency because it creates a gap where trade goods can be effectively arbitraged between low and high inflation countries until the currencies are fairly valued. When interest rates rise, aggregate demand slows and inflation declines.

The problem is deeper than inflation though, it is largely a debt and trade problem. After the 2000s rally in emerging market equities, capital flows have dropped considerably and creditors have demanded new debt to be priced in developed market currency in order to stop countries from printing money to pay off debt.

Even more, excessively low-interest rates in developed economies have allowed these countries very cheap money. Since 2008, the external debt to GDP of most emerging market countries has doubled or tripled. To be honest, no one seems to know exactly how much dollar-denominated external debt is in the world due to the fact that a large portion of it is in private banks that have been borrowing dollars. In China, in particular, there is estimated to be over $2.25 trillion in dollar-denominated debt in the country's banking sector.

The core problem with this form of debt is, although its low-interest rates are attractive to foreign borrowers, it creates a vicious feedback loop that is harming the entire global financial system. If an EM with high external debt sees higher inflation or devalues its currency, dollar-denominated debt is effectively higher in local currency.

This has been taking liquidity out of the global financial system and is the primary cause of ongoing EM currency devaluations.

Repo markets signalling a rally in the US Dollar

The repo market has been demanding to borrow U.S. dollars and none are appearing. The core problem is that interest rates are so low that investors have almost no money in money markets or their savings accounts.

Thus, the U.S. dollar will continue to rise and EM currencies will continue to fall until the Federal Reserve prints enough money that inflation spikes in the U.S. This will be the major shift that finally ends the low-interest-rate environment and renews monetary stability in emerging markets.

In simpler terms, the reason that developed world central banks have not been able to create inflation or economic growth is because most of their efforts to increase borrowing have flooded into EMs. Lowering rates causes foreign entities to borrow currency and offsets the liquidity impact of Quantitative Easing.

Overall, it seems that the monetary problems in emerging market economies are still not over. The U.S. dollar is breaking new highs for the year, and external debt is not being paid off in most countries. IMF debt packages can slow the bleeding but only serve to increase the problem in the long run.

This article was issued by Maria Fenech, Credit Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.