Federal Reserve Chairman Janet Yellen’s announcement this Wednesday that, for the first time in nearly a decade, U.S interest rates will rise, has divided opinion across the financial world.
One group of people who will unequivocally not be happy about this historic decision are Latin America’s central bankers who have spent the last few years trying -in vain- to defend the value of their rapidly depreciating currencies against the dollar.
In a region that relies heavily on exporting commodities a falling currency should be a good thing. It makes exports cheaper increasing the demand that will eventually kick start recovery.
Except this is not happening. The great commodity boom that began in the early 1990s, driven by China’s voracious demand for raw materials, now appears over as the Asian nation slips into a pattern of stagnant growth and possibly recession. Lower demand and lower commodity prices are set to stay, which, unfortunately for Latin America, means less demand for its currencies.
During 2015, the value of every single Latin American currency dropped against the dollar, a trend not just limited to the obvious candidates like Venezuela and Brazil where political turmoil, epic economic mismanagement and falling foreign investment have all contributed to lower domestic currency demand. Even the currencies of countries enjoying positive economic growth have fallen, notable examples being the Mexican peso (-15 percent) and the Colombian peso (-28 percent).
This gives central banks a major headache. Firstly a plummeting currency affects macroeconomic stability; imports become more expensive negatively affecting consumer purchasing power and investor certainty. Secondly, and most importantly, there is the problem of debt issued in foreign currency. In very simple terms a falling currency means that it’s going to take an ever increasing amount of domestic currency to pay off debt denominated in dollars.
Because of the so called ‘original sin’ and poor credit histories burdening Latin American countries, there is a lot of dollar denominated debt floating around Latin America. For countries like Brazil and Venezuela the situation is particularly dire. Riding the wave of the commodity boom these countries racked up huge dollar debts in the belief that they could be serviced or rolled over with rising or sustained commodity prices. The reality that transpired has been brutal. Oil which accounts for 96 percent of Venezuela’s exports once trading at $100 a barrel looks set to fall below $30 next year. Iron ore, Brazil’s biggest export, once trading at $150 per ton is now dipping below $40.
For these countries earning enough dollars to pay back their debts is now a gargantuan task. The markets have already lost confidence in Venezuela’s ability to pay as it heads for an expected default in 2016. Brazil, with its debt now downgraded to junk-status by S&P and its currency having already depreciated 36 percent, could eventually follow suit.
Interest on the up
Yellen’s decision turns the screw on the region a little harder. With higher interest rates on offer for U.S assets -backed by the financial credibility of the U.S Government- pulling capital out of Latin America and investing in the U.S is becoming a very attractive proposition. It might become a no-brainer if the U.S meets it growth forecasts of 2.5 percent and interest rates rise further. This will increase the demand for dollars and push their price relative to Latin American currencies even higher.
All the fundamentals therefore suggest that currency slide is a reality that just has to be accepted. Countries that have fought the market have only got burned. Peru’s central bank has blown a staggering $25 billion over the last 30 months buying up Soles on the foreign exchange markets in the hope of stemming its slide but it has done nothing to prevent a 13.3 percent Sol depreciation in line with the rest of the region’s currencies. Now it seems set to throw in the towel. They and other central banks know that the best course of action is simply to ride the economic slump, even if, as many forecasts suggest, commodity prices continue to fall in 2016.
For ordinary Latin Americans this means that dollars are once again the currency of choice for for saving and getting paid as just holding dollars in cash far outstrips interest rate returns on the most generous bank accounts.
Whatever happens, it is clear that for the foreseeable future, in Latin America, the dollar is king.