Latin American economies must prepare to cope with a surge in the value of the dollar in the wake of further hikes in US interest rates that could force China to stem an exit of capital, leading financial experts warned yesterday.
“I am concerned we could have a more dangerous situation when the Fed starts tightening,” Charles Collyns, managing director and chief economist of the Institute of International Finance (IIF), told Emerging Markets.
He said that if this led to a marked strengthening of the dollar’s exchange rate, that would make it more difficult for the Chinese to stabilise their currency.
“If you see continued capital outflows and continued intervention, then reserves could start to fall down to levels where the Chinese authorities worry that they are actually starting to become inefficient,” he said.
This would amount to a sea change following the recent positive trends supporting emerging markets. “When they see an end-game, everybody will move very fast. This may be a source of tension,” he said.
“It would be a very difficult situation in the markets, and the markets act pre-emptively. External conditions are likely to be more difficult. “If the Fed starts tightening more quickly because of internal pressures in the US and if China starts depreciation more rapidly against the dollar then you can have another reversion of risk appetite and another spike in market tension.
“That would lead to further withdrawal of capital from emerging markets including in Latin America, since Latin America is so exposed to China through the commodity sector, and so exposed to the US through capital markets.”
Such a reversal of capital flows would come as Latin America is suffering a fifth year of economic contraction with some of its biggest economies in recession.
“Latin America is in a difficult spot,” said Alejandro Werner, the director of the Western hemisphere of the IMF, even though it has benefitted from the recent pick-up in market sentiment, in line with other emerging markets.
SHOCK ABSORBERS
The way the Fed, chaired by Janet Yellen, chooses to raise interest rates will also be important. Werner thinks clear communication from the Fed should minimise distortions and spillovers.
“The accumulate capital flows in the past five years generate a source of instability, and both local monetary and financial policies, and also central bank policies in advanced economies, have to be watchful of these effects,” he said.
“It is an important source of risk for the region as a whole. The region has to work a lot on maintaining macroeconomic stability. The region cannot rely on a positive external [driver] fuelling an important recovery of growth. The next wave of growth will have to come from domestic sources, and for that productivity and investment should be the key.”
He added that central banks should continue to let exchange rates provide that adjustment and that those rate movements should avoid contaminating medium term inflation expectations. “Everybody is exposed to volatility and [countries of the region] have been managing it.”
Javier Guzman, deputy governor of the central bank of Mexico, said emerging markets should try to use their exchange rates as shock absorbers, maintain financial stability and set in motion a process of structural reforms.