As many of you are no doubt aware, certain emerging market currencies have been getting hammered in the markets recently due to a mixture of political and economic problems. Most notable among currencies that are suffering are the Turkish lira, the South African rand, and the Argentine peso.
The panic over the three aforementioned currencies have been spreading into other markets, such as Brazil. Now it looks as though Colombia may be under the gun too. While they lack the political chaos of Turkey or South Africa, many of Colombia’s underlying economic problems look very similar to those of other emerging markets which are currently struggling with currency crises:
Turkey is not the only one having big problems. The Argentinian peso, for instance, has lost 63% of its value this year and a 32% inflation is expected this year, which is especially unfortunate, as Argentina already has the highest interest rates in the world. The MSCI Emerging Markets Index, which measures the performance of 24 countries, has dropped 19% from its peak in January.
The main reasons for this negative performance are: first, investors´ fear regarding the trade war between the US, China and Russia, and second, the increase of the interest rates in the US which has caused a capital outflow from the emerging markets to the North American market, worsened by the credit bubble of countries like Argentina, South Africa and Turkey, which have borrowed nearly 260 billion dollars since 2010 according to the IMF.
Although 2018 seems to be the most impressive of the last 6 years in terms of economic performance, with an expected 2.6% growth and a 3.0% inflation, Colombia is still the most vulnerable emerging market after Argentina and Turkey. This can be explain by the high external debt (40% of GDP), deficit in the account balance, and low governmental effectiveness (the lowest of the top 5 most-vulnerable emerging countries) according to Bloomberg.
It is clear that Colombia doesn’t have the same vulture funds issues as Argentina, the diplomatic crisis of Turkey or the high inflation rates of both, but it does share two distinct features with the two other countries: Colombia is highly dependent on dollar-borrowing and has an increasing deficit in the balance of trade. Since March, Direct Foreign Investment has decreased from 913 to 546 million dollars, while 299 million dollars flew out of the country in Portfolio Investment following the high interest rates of the US.
When the 2008 crash happened, the Federal Reserve flooded the markets with trillions in liquidity in order to prop up US banks. This had the effect of making the dollar “cheaper” with so many trillions in extra dollars available. Now that the US seems to finally be making a real recovery, the Fed is starting to withdraw the liquidity it injected into the markets and unwind its balance sheet.
Because so many of the emerging markets have debt denominated in US dollars, as the dollar strengthens due to the Fed’s withdrawal of excess liquidity, the debt becomes more expensive to pay off. Even relatively stable prosperous South American countries like Colombia and Peru are starting to suffer from the impact of the rate hikes.
I am concerned about the potential for the region to destabilize if these Fed rate hikes continue for much longer. We do not want the immigration crisis to worsen if all the economies of the region roll over. The Fed should consider at least slowing the pace of the rate hikes to give these economies time to adjust to the new reality.