Fundamental Analysis – Emerging Markets and the US Dollar

The US dollar is the most important currency in the world at this very moment. It is the world’s reserve currency, and this comes as a tremendous privilege for the United States economy. Such a privilege allows the United States to run a huge deficit because the dollar is the one that denominates foreign transactions. Oil, for example, is sold in dollars. The United States, through its foreign policy, used its influence for oil to be sold in dollars by the Middle East countries, mostly OPEC (Organisation of Petroleum Exporting Countries), in return for protection in the region. Moreover, the proceeds from such transactions were directed to buying US Treasuries (government bonds). A process like this allowed the United States to run such a big deficit that it was/still is funding it. The Federal Reserve’s role became to simply make sure that the dollar is priced accordingly. Being the world’s reserve currency comes with some risks, too. The United States economy is the first one to react when unpredictable shocks occur. Before the US dollar, the Great Britain pound was the world’s reserve currency. Gold has been used in time to back the money in circulation, but nowadays there is only the fiat money concept in place. The Bretton Woods conference, named after the forest that surrounded the hotel in the United States where the conference took place, sealed the place of the dollar as the world’s reserve currency, and so confirmed the United States’ economic dominance. During those years, Europe was in a terrible shape, as war had caused tremendous disruption.

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The Dollar’s Role in Emerging Markets’ Economies

An emerging market is defined as a country that has some characteristics of a developed market, but doesn’t have all its standards. Emerging market economies, therefore, are trying to catch up with the front group and, in doing that, they borrow money. This money is used either to finance their own deficit or to develop much-needed projects in infrastructure and the like. The problem comes from the fact that these loans have to be repaid. The dollar being the world’s reserve currency, the loans are in dollars. Either the World Bank or other institutions broker a loan for a country at a specific rate, and for a specific project. If the interest rate in the United States rises, the dollars to be paid back become more expensive. This is suddenly a burden for the emerging market countries, which borrowed when the interest rate on the dollar was low and have to pay interest and principle on a stronger dollar. This gives the United States a negotiating privilege with the countries in this situation; all of which is just because the dollar is the world’s reserve currency.

Defining an Emerging Market

In 2010 a new report by a Spanish bank, the BBVA, made it easier to identify an emerging market. Based on a specific set of conditions that are met or not, countries are divided into eagles, eagle’s nest, and other emerging markets. Brazil, China, India, Russia, Turkey, Indonesia, and Mexico are in the first category. They are considered to be eagles, meaning that their Gross Domestic Product (GDP) in the next 10 years is expected to be larger than the average GDP of the G7 economies; that is, except the United States economy. In the nest category, countries are expected to have a GDP lower than the average of the G6 economies (G7 minus the United States). However, it must be bigger than Italy’s. Countries in this category are Nigeria, Peru, Saudi Arabia, Poland, and several others. The last category comprises countries such as Romania, Estonia, and the United Arab Emirates. It can be seen that several countries that are members of the European Union (e.g. Romania), or in the Eurozone (e.g. Estonia), are in the emerging markets category. In other words, an emerging market is one that is striving to be a developed one. It is not mandatory for emerging markets to stay like this forever. Developed countries can also fall into the category of emerging markets. So what is the deal with being an emerging market country or not?
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Strong Economic Demand

Emerging markets are characterised by a strong economic demand. Supply and demand cannot be satisfied by internal forces, so these countries have a deficit most of the time. This means that exports are less than imports. To finance this deficit, they need to borrow money, and these loans are in dollars, as explained earlier in the article. One should consider that a country has expenses and incomes. If there is more money spent than earned, a deficit appears. At the end of the day, money to cover the deficit is needed on a monthly or yearly basis, or sometimes on even shorter timeframes. As a result, everything that happens with the dollar affects these countries. All emerging markets countries have their own central bank, but there is not much to be done when the United States changes its monetary policy. In fact, many emerging market countries, such as Turkey, tried to manipulate their currency to prevent inflation from affecting their economies. This rarely works in the long run because the dollar policy is more important for the emerging markets’ creditors.

For Forex traders who are trading emerging markets’ currencies, knowing when and how the Fed is moving on rates, or is changing its monetary policy, is key. The funny thing is that the countries in the emerging markets category are the most populated ones. Strong demand for various products is expected from both emerging markets and developed ones. Imagine just China, Brazil and India; sum up the population number and you have an idea about what true demand looks like. Being able to satisfy such a large number is not possible these days. In the world of finance, as in others, it is all about money and influence. How much influence can the dollar buy? and how much will emerging markets have to pay when the interest rate on the world’s reserve currency, the dollar, changes?

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