As the virus spreads and the dollar appreciates, what of emergent economies?by Megan Greene / April 7, 2020 / Leave a comment
In many ways the novel coronavirus is the great leveller, infecting rich and poor alike, indifferent to national borders. It has also sparked a universal challenge for countries: a global shortage in dollar funding. This problem however will hit emerging markets (EMs) much harder than developed ones, and they are likely the next domino to fall in this crisis.
In mid-March, those of us who follow the markets noticed something really unusual. In the face of a massive exogenous shock, not only were equities falling—to be expected—but the value of Treasuries, the world’s safe haven asset of choice, was also plummeting. The cause was a massive shortage of US dollars as investors globally liquidated assets to get their hands on cold, hard cash.
The US dollar is the global reserve currency—it is the most universally accepted means of payment and store of value. As investors competed to acquire the greenback, its value appreciated relative to most other currencies. Foreign governments and companies conducting a lot of transactions in US dollars saw dramatically increased funding costs and increased costs of hedging their currency exposure. These fluctuations were most obvious in the currency derivative market, where the premiums for cross-currency basis swaps widened significantly, suggesting a spike in demand for dollars.
Quick to recognize signs of a dollar funding crisis from 2008, the Federal Reserve intervened swiftly by improving the terms of or opening swap lines with 14 foreign central banks, including Brazil, Mexico and Korea. Swap lines allow foreign central banks to borrow dollars from the Fed in exchange for the equivalent amount in their local currencies, so that the Fed effectively provides dollars to the entire world. The Fed also announced repo operations so that foreign banks holding US Treasuries could park them at the Fed in exchange for dollars.
The Fed’s intervention has significantly eased the dollar funding crisis for developed markets, and cross-currency basis swap premiums have fallen. But the pressure is still mounting for a number of emerging markets. This is partly because the Fed’s swap lines have mainly been opened with developed country central banks, though the swap lines eased the pressure on exchange rates in Brazil and South Korea.
Emerging market debt is particularly exposed to a US dollar crunch and…