The Forces At Work As Developed World Currencies Diverge
Sober Look | Feb 01, 2015 02:23AM ET
As Europe still manages fallout from the SNB breaking the Swiss franc peg earlier this month, we can discuss emerging market countries that might feel similar pressure from Europe and the US soon. It is easy to forget the extent to which emerging market economies rely on other currencies:
| Source: Currency Substitution / Wikipedia |
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Of all major base currencies, the euro and US dollar have displayed the largest divergence in recent months as the US economy strengthens and the EU continues QE.
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The SNB’s action earlier this month is an interesting case study on countries pegged to a depreciating base currency. The SNB’s move was unexpected largely because the relative weakness of the Swiss franc looks positive for Switzerland at first glance. As an exporting nation, Switzerland benefits greatly from a weaker currency and greater trade competitiveness.
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The usual concern about devalued currency is inflation, though this was clearly not an issue for the Swiss.
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Instead, the SNB was concerned with the mounting foreign exchange reserves necessary to maintain their peg. The EU’s latest expected round of QE, along with CHF’s ongoing use as a safe-haven currency, forced the SNB to reach $500 Billion in foreign reserves.
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Such large European exposure and expected future easing outweighed the benefit of favorable terms of trade and lower risk of deflation that came from weaker currency.
Turning to other euro-pegged countries, we see a similar trend in foreign exchange reserves.
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| Source: Trading Economics |
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In contrast, the US dollar has appreciated on recent strong economic news, and USD-pegged countries should be drawing down on foreign currency reserves to strengthen their domestic currency. Though recent evidence is weak, we may see further draw-downs soon:
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Unlike euro-pegged currencies, stress on US dollar pegs will be far more direct: countries will draw down on foreign exchange reserves as the first line of defense. This will generally result in tighter monetary policy at a time these nations struggle with slower global growth. Once they can no longer buy domestic currency in open markets, they may turn to grimmer deflationary measures such as seizing currency through higher taxes. For now, we’ll have to watch out for USD-peg avoid speculation (Hong Kong).
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