In Colombia the dollar reached a new historical maximum and in the world, it advance does not stop. Fears of a global recession and the rise in interest rates by the Federal Reserve make investors seek refuge in the United States currency, devaluing the currencies of other economies and generating significant challenges for emerging economies.
Why is the dollar a safe haven?
The United States is one of the few countries that is indebted in its own currency, so the probability that it will not meet its credit obligations is lower than other countries; EEUU can print dollars to pay its debt. The story for emerging economies is different, they have external debt in dollars and other currencies, so in the face of difficulty meeting their obligations, they must print money, which entails a strong devaluation that makes their indebtedness more expensive and seriously affects their economy.
So, under an event where the stability of the global economy is compromised, investors turn to safe havens such as the dollar or gold to protect themselves from a possible devaluation of other currencies. Today, with the Central Banks sharp rise in interest rates, investors do not rule out a global recession and that is why they are taking refuge in the dollar.
Why raising interest rates affects the economy?
The increase in interest rates is due to the rise in inflation. Central banks must take care to maintain the purchasing power of the currency and economic growth in the long term, so they make this adjustment in the first place to moderate the rise in prices and in the second to remunerate savers with an appropriate interest rate to inflation.
As the interest rate rises, over time the economic dynamic slows down, inflation moderates, and the Central Banks can return to a path of lower interest rates. This cycle is usually repeated decade after decade and the task of the Central Banks is to have smooth cycles that do not generate recessions.
However, with the pandemic and interest rates so low, it seems that the economic cycle and inflation have gotten out of control, so the recent interest rate adjustments have been stronger and would be leading to great global financial instability. To this we must add the impacts on inflation of the conflict in Europe.
What does it imply for emerging economies like Colombia?
For emerging economies there is an additional risk factor. When the economy deteriorates, investors tend to sell public debt in response to a greater probability of default and take their capital out of the country. With the sale, the interest rates of the bonds rise and if the governments do not adopt measures to improve their payment capacity, capital flight could strongly devalue the currency.
To stop the capital flight, the Central Banks raise their interest rates trying to make investment in the country more attractive. But without a clear commitment from the government to balance its fiscal situation, the capital would not have the motivation to return to the country and the devaluation could spread as in Venezuela and Argentina.
This explains why, in global risk scenarios, emerging currencies are devalued, bonds rates rise, and Central Banks increase their interest rates.
Why is the Colombian peso devaluing more than other currencies?
In these risk scenarios, currency devaluation acts as a stabilization mechanism. It makes exports more attractive and imports less attractive, helping economic growth. Remember that exports add to GDP and imports subtract from it.
However, the current government wants to curb the dynamics of the mining and energy sector, which is responsible for 50% of exports, and plans to buy land with the issuance of bonds, increasing the country’s indebtedness. This makes investors see the country as riskier as it has less income and more debt.
Although the tax reform is a good step towards having more income and generating more peace of mind, for some analysts, taxing the country’s productive apparatus so heavily can be interpreted as a blow to economic growth and, according to the Laffer curve, it could end up collecting less taxes in the medium term, nullifying the positive impact of the reform.
What steps can emerging economies take?
To deal with this type of crisis, emerging markets must boost their export sector to the maximum to bring in dollars and create jobs. Policies must be adopted to attract foreign investment to finance the current account deficit and mitigate devaluation. Unfortunately, the emerging economies, due to their need to import manufactured goods, are largely dependent on external capital inflows and for now they will remain highly dependent on what happens in the international environment.
