What else can EM central banks do to protect their currencies?

David Rees, Senior Emerging Markets Economist at Schroders

Where they don’t have foreign exchange reserves to fall back on, we expect to see monetary authorities opt for “emergency” rate hikes or possibly capital controls.

Emerging market (EM) central banks are becoming increasingly sensitive to currency depreciation and several have sold down a significant portion of their foreign exchange (FX) reserves to slow the pace of decline.

Most EMs have sufficient reserves to avoid old fashioned crises, but additional pressure on currencies could see some take more aggressive action to prevent further depreciation. Swap lines and interest rate hikes are the most likely course of action; however, some could consider capital controls if the US dollar continues to march higher.

South Africa finds itself in a position of relative strength. While the rand is clearly not immune to a generally stronger US dollar,
South Africa’s relatively solid fundamentals mean that further currency depreciation is unlikely to cause policymakers to panic. The balance of payments are in good shape, South Africa has been one of the few EMs to accumulate FX reserves over the past year and the market already prices in a positive real interest rate. Indeed, these factors are likely to attract investors once the global backdrop stabilises.

The resilience of EM currencies has often been overlooked during the current market chaos. While the US dollar index (DXY) has appreciated by about 25% since mid-2021, EM currencies which are not included in DXY have generally fared less badly. Indeed, some such as the Brazilian real have eked out positive total returns against the dollar supported by a combination of large interest rate differentials, cheap valuations, light positioning and positive terms of trade shocks.

However, foreign exchange liquidity – particularly of US dollars – is clearly being squeezed as aggressive interest rate hikes in developed markets, deteriorating demand for EM exports and risk-off sentiment have driven capital outflows.

High frequency data point to fairly large outflows in recent weeks and EM central banks have clearly become more concerned, running down FX reserves to support their respective currencies. In particular, central banks in the Czech Republic, Chile and Thailand have seen their reserves fall by a fifth since the US dollar started to surge.

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