Tanking currencies are bad news all round

As the Turkish lira went into meltdown last week, one consolation for the country’s businesses might have been that, while their foreign currency debts were becoming harder to service, at least their products were becoming more competitive on export markets.

By conventional wisdom, the same should be true for businesses in Argentina, Brazil, Russia, South Africa and other places that have seen their currencies fall against the US dollar this year.

Yet the data persistently fail to show any advantage gained by exporters from a weakened currency. Indeed, for both trade and investment, traditionally the twin engines of emerging market growth, the strengthening dollar looks certain to be bad news.

Back in 2015, EM Squared compared movements in 107 currencies with real or forecast changes in trade and found that, on balance, a weaker currency was followed by a decrease, rather than an increase, in export volumes.

We have run the data again, for 125 countries this time. Comparing trade volumes in the first quarter of this year with currency fluctuations in 2016, we get the same results, as the first chart shows.

By conventional wisdom, the bigger the fall in a country’s currency, the greater the rise in its export volumes. But the line of best fit shows that this did not happen: the bigger the depreciation, the smaller the rise in export volumes; and the best way to achieve a rise in exports was to have had no depreciation two years earlier or, preferably, a currency appreciation.

Yet the data do not all go one way. When comparing import volumes with currency movements, we find some support for conventional wisdom, as the second chart shows: the more a currency depreciates, the less is the rise in import volumes, as imported goods become more expensive for local buyers.

One explanation for the failure of a strong dollar to drive EM exports is offered by a working paper published earlier this year by the Bank for International Settlements. It finds that a strengthening dollar has a detrimental impact on exports because it makes finance more expensive, and that this financial channel outweighs any competitive edge gained by exporters from weakness in their own currencies.

The BIS paper highlights the rising significance of global value chains (GVCs), fostered by a long period of easy dollar credit conditions that helped to build GVCs and to finance their inventories. The tightening of dollar credit associated with a stronger dollar, it argues, will curtail GVC activity, to the point that “paradoxically, a weaker currency against the dollar may actually serve to dampen trade volumes, rather than stimulate them”.

“We know from the evidence that a strengthening dollar will lead to tighter conditions globally, and that this will be associated with a higher threshold for the supply of credit,” said Hyun Shin, head of research at the BIS and co-author of the paper. “This is not just about dollar funding but about the impact on the real economy as well.”

However, doubts persist about the effect of devaluations on exports. Reinout De Bock, chief economist at Pharo Management, a London-based hedge fund manager, said the effect of the financial channel has been hard to quantify, especially in the context of an increase in the use of protectionist measures over the past decade whose impact has also been hard to quantify.

It is very hard [for governments] to devalue into competitiveness. The greater their credibility, the more capital flows will return. Places that have a hard time attracting FDI have a harder time in improving productivity

He advocates looking at currency depreciations in EMs in three groups: a large depreciation, of 30 per cent or more in three months; a medium one of 20 to 30 per cent in three months; and a small one of 10 to 20 per cent.

Any depreciation will have a commensurate impact on the price of imported goods, hitting growth as consumption and real investment fall, he said. While this effect can last for several quarters, the impact on growth tends to last beyond a year only in the case of large depreciations, he said. 

A large depreciation, he added, will lead to a large decline in the real exchange rate, as non-tradable goods and services adjust slowly. And this, he said, will improve export competitiveness.

But at what cost? With the Turkish lira hitting 4.65 to the dollar this week, bringing its fall in dollar terms to 18 per cent this year, Charles Robertson, chief economist at Renaissance Capital, wrote on Tuesday: “In the long-run, the markets are actually giving Turkey what it needs, even if Erdogan doesn’t get that: a weaker currency that would shift the model from debt-fuelled consumption growth . . . to export-led growth.”

But he added: “In the short-run, the weakness of the lira will 1) hit bank lending, 2) hurt investment/consumption growth, 3) push GDP growth down to 2-3 per cent (in a good scenario). Plenty of downside risk, with a Brazil-style growth crisis threatening to deliver zero or negative GDP growth.”

Even the most valiant currency warrior — a figure given to us by Guido Mantega, then Brazil’s finance minister, in 2010, in the belief that the US and China were seeking an edge through currency manipulation — would surely balk at that.

The plummeting currencies of Turkey and Argentina are, so far, and assuming contagion does not spread, the exception. As US interest rates and the dollar have risen, they have been punished for their current account deficits and other imbalances, and for their policy mistakes — even though, in Argentina’s case, this was a matter of execution rather than intent.

Typically in emerging markets, foreign exchange vulnerability has been one spur among others to reform. More important than any edge for exporters, said Mr De Bock at Pharo, is the blow to policymakers’ credibility from sudden and large depreciations, and the consequence damage to a country’s ability to attract foreign direct investment.

“It is very hard [for governments] to devalue into competitiveness,” he said. “The greater their credibility, the more capital flows will return. Places that have a hard time attracting FDI have a harder time in improving productivity.”

A tanking currency may indeed be bad news all round.