When the dollar flexes its muscles, the pain doesn’t necessarily just stay confined to the FX market. And I reckon we’re starting to see emerging economies in Asia get a rather uncomfortable reminder of that.
With 10-year Treasury yields hovering around 5.30% and the dollar running up to a near 18-month high, investors have good reason to favour US assets at this juncture. It’s a simple response to the question of why bother taking additional risks elsewhere when US government debt is paying such lucrative returns?
And that is where the problem begins to grow. Money moving towards the US often means money moving away from emerging markets. And for countries like Thailand and Indonesia, they are finding themselves caught in the middle.
The Thai baht is an example of that, with USD/THB rising by nearly 7% so far this year. Beyond the dollar’s resurgence, Thailand is already struggling with a more sluggish economic recovery and a tourism sector that has yet to fully regain its footing.
Besides that, higher oil prices are not helping either. Thailand relies heavily on imported energy and so a weaker baht makes it even more expensive to fund oil buying in local currency terms. As such, that risks adding another squeeze on households and businesses that are already dealing with rising costs.
Indonesia faces a similar problem, albeit with a different set of domestic concerns adding to the pressure. The rupiah has been under pressure from global capital flows, while worries over fiscal policy and central bank independence back home have given investors even more reason to be cautious about the local currency.
That has led to USD/IDR hitting fresh record highs in June and is starting to wander back there again in recent weeks.
Indonesia’s central bank has been trying to alleviate the pressure by leaning on currency stabilisation measures. But with Treasury yields staying elevated, keeping foreign capital interested in local assets isn’t exactly easy to do.
And that’s not the end of it. In fact, this is where things can get rather nasty.
Just imagine an Indonesian company owing $1 million in dollar-denominated debt. If the rupiah were to weaken, then that same debt will suddenly cost more to repay in the local currency. And that is despite the company not even borrowing another dollar.
Now throw in higher inflation risks, more expensive imported goods and investors withdrawing money over concerns about the economic outlook.
All of a sudden, we’re starting to see a rather vicious cycle start to develop. The currency weakens further, thus making dollar-denominated debt harder to service. And in turn, nervous investors may decide to move even more money out of the local currency and into the dollar.
That’s the feedback loop.
The stronger dollar puts pressure on emerging markets and the resulting capital outflows can end up feeding even more demand for the greenback.
Having said that, it doesn’t mean that the cycle cannot be stopped once it is set in motion. There is of course the fact that central banks can intervene and things like stronger exports or improving investor confidence can provide some relief.
But with Treasury yields staying elevated, emerging market currencies may struggle to find a lasting reprieve without some relief from the dollar itself.
This article was written by Justin Low at investinglive.com.