Emerging Markets Weekly

Investors concerned about how U.S. government and central bank policies will affect emerging markets over the next few years are focusing on the potential side-effects of these policies on the U.S. dollar.

Trillions of dollars in additional government expenditure will likely lead to higher bond yields and a weaker dollar necessary to finance the U.S. budget deficit. This will lead to higher commodity prices. Moreover, expansionary monetary policy by the U.S. Federal Reserve Bank will also have repercussions for the dollar in that dollars will leak out the trade account and cause the currency to depreciate over the long term.

1) Commodity price effects:
Since commodity prices are priced in U.S. dollars, a weaker dollar leads to higher overall demand for commodities and higher commodity prices. Therefore, a weaker dollar benefits energy exporters such as Russia where government finances and exports are tied to oil and gas prices. In fact, there is a very high correlation between oil prices and the level of Russia’s stock market.

Investors can expect that a weak dollar will benefit Russia most out of the four BRIC nations due to its effects on commodity prices. The terms of trade shock will also coincide with a higher value for the ruble. Brazil, also a commodity exporter, is also expected to benefit from this phenomenon.

India, on the other hand, is a commodity importer. The government subsidizes the price of oil and fertilizer which are major budgetary expenses. Therefore, a falling dollar could be most detrimental to India’s budget and hence its economy and its currency.

A weak dollar and rising commodity prices are also inflationary. In the current economic environment, characterized by rising unemployment and idle machinery, the likelihood of sustained inflation is highly unlikely. However, over the long term, rising inflation is a likely outcome.

2) Export effects:
A weaker dollar caused by inflation in the U.S. leads to higher import prices and eventually to a substitution effect of domestic consumption for foreign imports. This will only happen after the U.S. trade deficit rises as expansionary monetary policy increases U.S. imports. In other words, it will correct for a rising U.S. current account deficit.

Over the long term, the effect of a weak dollar and inflation are therefore detrimental to export-dependent nations. However, China has largely pegged its currency, the RMB, to the dollar allowing for mild appreciation on a long term basis. Therefore, a fall in the dollar will not necessarily cause a serious impact on imports from China, assuming the fall in the dollar is orderly, and will certainly be mild in comparison compared to the effects of the U.S. credit crisis on China's economy.