23 July 2019
A strong dollar plus rising US rates would put a heavy burden on emerging economies and threaten their financial safety. Photo: Bloomberg
A strong dollar plus rising US rates would put a heavy burden on emerging economies and threaten their financial safety. Photo: Bloomberg

A stronger dollar could trigger the next financial crisis

Let’s revisit how the Hong Kong market collapsed in the second quarter of 2015.

The Hang Seng Index slumped as much as 36 percent to 18,278 points on Feb. 12, 2016, from a high of 28,588 points on April 27, 2015. Stock markets largely displayed similar bearish patterns, although the size of decline varied.

While analysts came up with different explanations for the bear cycle, I believe the Federal Reserve’s tapering moves were the main culprit.

The Fed moves triggered a spike in the dollar index, which soared over 25 percent within one year since the tapering began in 2014. And in 2015, investors began pulling massive capital from emerging markets.

Now, if the greenback shows a clear reversal of a downtrend that has lasted for 14 months, this may again have a far-reaching impact on global financial markets – and emerging markets, in particular.

A number of factors point to a stronger dollar in the second half of this year.

Robust US economic growth and rising inflation could quicken the pace of rate hikes.

Spiking US Treasury yields may further widen the interest spread between the United States and other countries.

The US tax reform, including the move to slash repatriation tax, would encourage more American corporates to bring home their capital.

Some might argue that emerging economies are now in a much better shape than they were in 1990s in terms of economic structure and foreign exchange reserves. Hence, they should be better prepared for another financial crisis.

But I’m concerned that emerging markets are still vulnerable to another looming financial crisis for two reasons.

In the short term, commodity prices, especially oil, are likely to move in line with a stronger dollar. But the dollar strength would eventually hurt commodity prices and weigh on emerging economies.

Second, emerging markets have been witnessing rapid credit expansion, which increases foreign exchange and default risks.

The overall credit extended by non-financial institutions in all emerging markets spiked to US$51.8 trillion by the third quarter of last year, up 1.9 times from US$17.7 trillion in late 2008. That represents an annual growth rate of 13.5 percent, compared with 2.5 percent in the developed world over the same period.

Credit-to-GDP ratio in emerging markets also soared to a record high of 192 percent. That means credit growth has far outstripped economic growth.

Bloomberg estimates that US$400 billion to US$600 billion in US debt will be due in emerging markets in the next three years. As such, a strong dollar plus rising US rates would put a heavy burden on emerging economies and threaten their financial safety.

The market should closely watch three main indicators to gauge such risks: the emerging market currencies index, emerging markets’ capital flow, and changes in global central banks’ foreign exchange reserves.

This article appeared in the Hong Kong Economic Journal on May 17

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist

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