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Why stronger dollar poses a problem for emerging markets

us dollars

The value of dollar deposits held by Kenyans in local banks rose by 68 percent to a record Sh1.55 trillion. PHOTO | SHUTTERSTOCK

The US dollar is having its best run in years. That’s great news for Kenyans exporting overseas because a favourable exchange rate gives them more bang for the buck. It’s not such great news for international investors in local securities.

An unfavourable exchange rate takes a bite out of returns. This is because when they convert dollars into a depreciating shilling to buy local securities, it drives the daily net asset value of the fund lower. The solution: stay out (it's too late and too expensive to hedge anyway).

On the other hand, reflecting on worries such as our dollar-denominated debt facing the added risk of higher repayment costs amid stubborn inflation in the West, local investors are finding their “solution” in dollar money market funds.

I guess the fundamental objective is to benefit from short to medium-term US dollar-denominated opportunities through income and/or capital preservation in addition to hedging currency risk associated with the shilling.

But let's understand this rationale a bit deeper. A stronger dollar poses a problem for risk assets (read: emerging and frontier markets). Because of the dollar's central role in the global financial system, its fluctuations have widespread repercussions.

In our case, a stronger dollar tends to tighten global financial conditions while diminishing the appetite for risk-taking. This means a flight to quality (read: sell-off in developing markets). With foreign buying accounting for most of the action in these markets, the absence of dollar inflows further weakens them.

And so, if rates and the US dollar stays/continues higher, local investors have to look for better and more secure returns. So far, they have flocked to the higher yields attached to Treasuries (classic safe-haven behaviour), and now the dollar money market completes the picture.

MSCI’s index data proves this. Its US dollar-based index for emerging frontier market stocks in Africa (MSCI EFM) only bagged two percent last year while the MSCI USA and the MSCI World returned 27 percent and 23.79 percent, respectively, in the same period.

In fact, going back 10 years, the same index annualised 0.36 percent in gross annual returns while the MSCI USA and MSCI World generated 11.36 percent and 8.6 percent, respectively, in the same period.

Is this a solution only for investors? Not necessarily. Say a small-value importer plans to order goods from China in 3-5 months. Fearing further depreciation of the shilling and avoiding “expensive” forwards or swaps, he/she could execute a “money market hedge” to lock in the value of the US dollar at the spot rate.

How? They only need to place the dollar value of the anticipated transaction with a dollar money market fund for 3-5 months (receiving interest in the time period).

Even if the dollar strengthens relative to the shilling during the investment period, the importer knows exactly what the transaction cost is going to be in dollars and can budget accordingly.

In all, as we witness the biggest rally in the US currency in 20 years causing a trend down in local security prices, local investors need not suffer. They have hedging options. Same as importers.

Mwanyasi is MD, Canaan Capital.