Capital competition in emerging markets

In the last few years, a trend has developed amongst the policymakers in countries with developed economies (namely the US, EU and Japan): reducing interest rates to near-zero levels in order to stimulate growth and maintain employment against the negative impact of the 2008/2009 financial crisis. The thinking behind this initiative is twofold: encourage the use of credit facilities in business and industry, and inspire consumption (the main driver for growth in any country).

When negligible interest rates fail to stimulate economies, these countries resort to large-scale asset purchases – such as corporate bonds or mortgage-backed securities – leading to a situation where a developed economy has a lot of money in the system without the higher interest rates (and therefore yields) that attract investors. This causes investors to turn to emerging markets like South Africa (SA), which present a worthwhile risk against the low returns of established economies.

So what happens when developed economies or countries with similar risk profiles raise interest rates? Take Turkey (which saw major interest rate increases earlier this year) for example; what impact would this have on an emerging market like SA?

The answer is simple. When Turkey raised its interest rates, it offered investors better returns than SA, forcing SA to review its interest rates in order to maintain its competitive edge.

The situation is further intensified if a more-developed economy than Turkey raises its interest rates. They are deemed as low risk, but are now offering a higher return; this is the situation where you will see a typical risk-on risk-off scenario, and an exodus of investment from emerging markets.

Most emerging markets are typified by their large foreign debt and denomination in offshore currencies. In economic terms, this is characterized as a large current account deficit and a heavy dependency on foreign capital inflows. In this setting, policy makers have to find incentives or policy measures to stay ahead of the capital competition.

Three of the BRICS countries – namely Brazil, India, and South Africa – are considered particularly exposed to an exodus of foreign capital, which is why all these countries have seen increases in interest rates over the past few months. It’s not a huge coincidence that many interest rate hikes (and Argentina’s currency control relaxation) occurred just after the US decided to scale back on its asset purchasing program.

The US dollar is the world’s leading reserve currency; a weak US Dollar translates to weaker currency reserves. Emerging markets should find ways to protect themselves from such foreign capital challenges, for instance to have measures that channel foreign capital into long-dated investments that will sustain growth and development. But the sheer power of developed economies will still always be felt, so it is crucial for developed nations to act with great responsibility and to work together with emerging economies to reduce the adverse effects of their own policies.

For FX investors, the possibility of increased risk – and the investment opportunity that comes with it – is clear. The effects of a major economy deciding to change rates without due diligence would be considerable, and such volatility could have a marked effect on all markets. Binaries are one of the ways investors could take advantage of this volatility, by tracing the ripples from major announcements to predict their impact on various FX markets. Though of course, despite their limited risk, the possibility for significant loss also remains.

Keeping a close eye on international economic developments is sometimes not enough for successful forex investment, without an idea of how underlying factors may play out. Understanding these factors, though, can reveal multiple new avenues for binary trading.

Charles Ntjana works on IG’s CFD trading floor. For more information: http://www.ig.com/uk/cfd-trading

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