Financial Stability Implications of Emerging Market Currency Developments
IMF Blog, July 22, 2024
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Bibliographic details
- Authors: Tobias Adrian, Fabio Natalucci, Jason Wu
- Published: July 22, 2024
Overview
- Authors: Tobias Adrian, Fabio Natalucci, Jason Wu
- Date: July 22, 2024
- Context: Emerging markets navigating high global interest rate volatility; global soft landing remains the base case per the July World Economic Outlook update.
Recent currency movements and macro drivers
- Emerging market currencies have declined by about 4 percent year-to-date, on net, against the US dollar.
- Latin American currencies have dropped 5 percent.
- Currencies in Asian emerging markets are lower by 4 percent.
- Central and Eastern European and African currencies saw milder depreciations.
- The forecast for economic growth in emerging markets edged up to 4.3 percent for both this year and next.
- Key driver: narrowing interest rate differentials vis-à-vis the United States as expectations for Federal Reserve rate cuts dissipated and the US dollar appreciated.
- Countries with the most pronounced narrowing—particularly several Latin American countries that reduced policy rates this year—or those with the lowest interest rate differentials, including some Asian emerging markets, experienced the largest exchange rate depreciations.
- Other factors: country-specific fiscal concerns or political developments; some central banks slowed or paused rate hike cycles, or conducted foreign exchange interventions to manage currency volatility.
Financial stability risks from currency movements
- Orderly depreciation toward fundamentals can be constructive; abrupt selloffs can trigger financial instability.
- Sudden foreign capital outflows risks:
- Severe asset price declines.
- Funding gaps.
- Intensified foreign exchange mismatches in financial institutions.
- Inability to rollover foreign currency (particularly US dollar) funding at reasonable costs.
- Rapid loss of investor confidence in emerging market financial markets.
- Empirical outcome so far: those abrupt destabilizing outcomes “haven’t been the case this year.”
- However, with an uncertain global backdrop and market sensitivity to data, central bank communications, and political uncertainty, outflow pressures could spike suddenly, forcing trade-offs between stabilizing domestic conditions and fending off external pressures.
Policy responses and recommendations (consistent with the IMF’s Integrated Policy Framework)
- Foreign exchange intervention:
- Can be helpful when sharp depreciation poses material financial stability risks due to balance-sheet mismatches or threatens to de-anchor inflation expectations.
- Especially useful when markets are shallow or outflows cause market liquidity to seize up.
- Capital flow management measures:
- May be needed as part of a broader policy package if the situation deteriorates to imminent crisis.
- Limits and complements:
- Interventions and capital flow measures cannot substitute for fundamental macroeconomic adjustments; should be part of broader plans to address underlying imbalances.
- Macroprudential policies (for example those targeting asset and home prices, and those reducing FX mismatches on borrower balance sheets) can be potent complements.
- Stress tests to identify systemic troubles from external pressures can help mitigate risks before they materialize.
- Communication and commitment:
- Most emerging market central banks remain committed to policy frameworks that target domestic inflation and economic conditions rather than exchange rates per se.
- Faithful adoption of inflation targets may lessen pass-through of currency depreciations to domestic conditions, as shown by recent IMF Regional Economic Outlook work.
- Policymakers in several countries have communicated that recent interventions were the exception, not the rule.
- Risk management imperative:
- Prudent policymaking should emphasize vigilance and planning for adverse scenarios; risk management should be the central tenet of financial policies.
Key statistics and facts (verbatim)
- "Currencies have depreciated to varying degrees in emerging market economies as interest rate differentials with the United States narrowed"
- "emerging market currencies have declined by about 4 percent year-to-date, on net, against the US dollar"
- "Latin American currencies have dropped 5 percent"
- "currencies in Asian emerging markets are lower by 4 percent"
- "projections edging up to 4.3 percent for both this year and next"
Source: IMF blog "Financial Stability Implications of Emerging Market Currency Developments", Tobias Adrian, Fabio Natalucci, Jason Wu; July 22, 2024.