Photo: Reuters/Kim Hong-Ji
Photo: Reuters/Kim Hong-Ji

If protectionism is not a good explanation for the sell-off in emerging markets (EM) since Donald Trump’s US presidential election victory – and it is not – what’s a better explanation?

I have argued elsewhere that the strong dollar is one of several market signals of improved optimism about US growth under a Trump presidency.

Since the total returns of other countries are generally calculated in a way which also includes the appreciation/decline in their currencies in addition to the return on the index in its own domestic currency terms: then a strong dollar will automatically tend to detract from the overall return of stock indices in countries which are denominated in the currencies which the dollar strengthened against.

But that is not the only effect of a strong dollar on EM. The underperformance of the EM currencies is not large enough to explain the underperformance of the indices on a total return basis. In other words, investors lost money in EM in the stock markets on top of the losses in the currency markets.

There must be something else going on. There is, and it also involves a strong dollar, but in an indirect way. Many emerging market countries have been borrowing money in dollars rather than in their own currencies (for more on this just Google ‘Yankee Bonds’). These countries have noted that interest rates for the dollar have been extremely low.

Why pay sky-high peso interest rates when you can pay financially suppressed dollar interest rates? Well you do pay a price for that lower rate: you add currency risk to your financial outlook. If you borrow dollars and have to pay interest in dollars and eventually have to repay the principle in dollars, then you are running a risk that the dollar will go up in value. You’ll have to pay back dollars which are worth more than the dollars you originally borrowed.

If you are transacting business in, say, the Mexican peso or the Brazilian real and those currencies plunge in value next to the dollar, you’ll have to take your peso or real denominated profits and use those devalued currencies to buy expensive dollars to make your debt service payments. If your currency declines in value 10 percent in relation to the dollar, then you’ve basically increased your Yankee Bond debt by a tenth. Ouch.

So the Yankee Bond hypothesis makes sense on the surface, but does it hold up to the data? It certainly held up to the first data test we applied to it: Latin America significantly underperformed emerging Asia, and Latin America has many more Yankee Bonds.

Emerging Asia had learned its lesson during the “Asian Contagion” of the late 1990s and since then has been very careful about its debt levels and particularly to its exposure in the area of foreign exchange. It (barely) lived through a strong dollar patch and it did not want to go through all of that again. Latin America did not learn that lesson.

We decided to run a series of analyses which look at correlations between individual countries’ dollar denominated debt. We found that for emerging markets, there was a negative correlation between USD debt as percentage of GDP (and also as percentage of total foreign reserves) and performance of the country total return. In other words: the more USD debt they had, the more they underperformed the rest of the EM world.

Significant factor

Clearly dollar liability exposure is a significant factor in explaining an individual country’s underperformance. But clearly it is not the only factor.

For example, Chile’s returns have been significantly higher than one would expect given very high levels of dollar liability exposure, but copper export is a major source of revenues for Chile and copper has appreciated in value significantly since Trump’s election. In other words: part of Chile’s performance is caused by appreciating copper prices.

For another exception, Russia was the single best performer in the two weeks following the election, at least partly because expert opinion finds Russia much more likely to be freed from financial sanctions under a Trump administration, given his Russo-phile sympathies in contrast to Clinton’s “blame Russia first” tendencies. In other words, Russia’s appreciation appears to be much more driven by shifting diplomatic winds in its favor than by any other factor.

But exceptions are only exceptions in the presence of a pattern and the pattern is that countries which are exposed to dollar liabilities in a strong dollar environment have been hit hard.

We don’t have a protectionism story here: we have a floating currencies story. And Asia has been better prepared to weather that particular storm than Latin America.