By Peet Serfontein
Exchange rates play a crucial role in the economic stability and growth of any country, but they are particularly significant in emerging markets. These markets, including countries such as South Africa, Brazil, India and Turkey, often experience higher volatility in their exchange rates due to factors such as capital flows, political uncertainty, and global economic trends. Understanding how exchange rate mechanisms function in these economies is essential for policymakers, businesses and investors alike.
Exchange rate regimes
Exchange rate regimes in emerging markets can broadly be classified into three main categories, namely fixed exchange rates, floating exchange rates and hybrid (or managed) exchange rate systems.
The 1997 Asian currency crisis highlights risks attached to a fixed currency
In 1997, the Thai baht collapsed after the Thai government was forced to float the baht due to lack of foreign currency to support its currency peg to the US dollar and several speculative attacks on the currency prior to the forced float. Capital flight ensued almost immediately, beginning an international chain reaction. At the time, Thailand had acquired a significant burden of foreign currency denominated debt. As the crisis spread, other Southeast Asian countries and later Japan and South Korea saw slumping currencies, devalued stock markets and other asset prices, as well as a major rise in private debt.
Thailand's booming economy came to a halt. The baht lost more than half of its value and the Thai stock market dropped 75%. Poverty and inequality increased while employment, wages and social welfare all declined because of the crisis. It took the country about four years to recover from the shock and required intervention from the International Monetary Fund.
Factors affecting exchange rates in emerging markets
Several factors influence exchange rates in emerging economies, making them more volatile compared to developed markets.One of the most significant factors is inflation. Countries with lower inflation tend to see their currencies appreciate over time, whereas those with higher inflation experience depreciation. Interest rates also play a critical role. Higher interest rates tend to attract foreign investment as investors seek better returns, strengthening the local currency. Conversely, lower interest rates can weaken a currency as capital flows out in search of higher yields elsewhere. The South African Reserve Bank (SARB) adjusts interest rates strategically to manage inflation and maintain exchange rate stability.
Another major factor is political and economic stability. Investors are more likely to place their funds in countries with strong institutions and predictable policies. Political turmoil or policy uncertainty can trigger capital flight, leading to currency depreciation. This is not only specific to the market in question - during periods of global economic pressure and policy uncertainty - there tends to be a so-called "flight to safety" resulting in capital leaving emerging markets to safe-haven markets and assets like gold.
Trade balances also influence exchange rates. If a country exports more than it imports, it generates a trade surplus, which strengthens the currency. However, if imports exceed exports, the increased demand for foreign currency weakens the local currency. Commodity-dependent economies, such as Brazil and South Africa, often see their exchange rates fluctuate based on global commodity price trends.
Challenges faced by emerging markets in exchange rate management
One of the biggest challenges faced by emerging markets can be currency volatility, which affects trade and investment. Rapid depreciation can increase the cost of imported goods and services, leading to inflationary pressure that can negatively impact growth. On the flipside, excessive appreciation can make exports less competitive, hurting local industries.
Another concern is capital flight, where investors withdraw their funds in response to economic or political uncertainty. This often leads to sharp currency depreciation, forcing central banks to intervene by using foreign exchange reserves or adjusting interest rates. The 2008 Global Financial Crisis and the Covid-19 pandemic highlighted the vulnerability of emerging market currencies to external shocks.
Debt in foreign currency is another critical issue. Many emerging economies borrow in US dollars or euros due to lower interest rates and better credit access. However, if their local currency depreciates, repaying this debt becomes more expensive, leading to financial instability.
Exchange rate interventions by central banks
Central banks in emerging markets often intervene to stabilise exchange rates and prevent excessive volatility. These interventions can take various forms, depending on the country's monetary policy framework.
The impact of exchange rate fluctuations on the economy
Exchange rate fluctuations can have wide-reaching impacts on various sectors of the economy.
For businesses engaged in international trade, a weaker local currency makes exports cheaper and more competitive in global markets. However, it also makes imports more expensive, increasing costs for businesses reliant on foreign goods and raw materials. This can lead to inflationary pressures, and negatively impact economic growth.
For consumers, a depreciating currency raises the cost of imported goods. In the case of South Africa, this will include electronics, fuel, and certain food products. This, in turn, increases inflation and reduces purchasing power.
The financial sector is also impacted by exchange rate movements. Banks and financial institutions with exposure to foreign currency loans or assets face risks when the local currency depreciates.
Exchange rate volatility can also affect investor confidence, influencing stock market performance and capital inflows.
In closing
For countries like South Africa, managing exchange rate stability is a delicate balancing act. Policymakers must consider inflation, interest rates, trade balances and external debt obligations when formulating monetary policies. Exchange rate fluctuations impact businesses, consumers, and investors, making it essential for governments and central banks to adopt sound economic policies to maintain stability.
Ultimately, the effectiveness of exchange rate mechanisms depends on a country's overall economic resilience, governance structures, and ability to adapt to global financial trends. By maintaining macroeconomic stability and implementing prudent monetary policies, emerging markets can mitigate the risks associated with exchange rate fluctuations and foster sustainable economic growth.
