The US dollar is in a new phase of depreciation, said Douglas Borthwick of Connecticut-based Faros Trading.
Starting from March 31, emerging market countries began to expect China to allow the yuan to appreciate against the US dollar at a quicker pace, said Borthwick.
In response, they also accelerated the pace of their currencies’ appreciation against the dollar.
They have three motives for doing this.
One, they want stronger currencies to deal with inflationary pressures. A strong currency lowers the cost of imported commodities. Moreover, less intervention to weaken their currency against the US dollar means less imported inflation from the Federal Reserve.
Chinese central bank officials have already said they want to use currency appreciation as a tool for combating inflation. This line of thinking is prevalent in other emerging market economies as well.
The Bank of Thailand, for example, recently signaled it would use currency appreciation to stem inflation. Moreover, it stipulated that the pace of appreciation must be comparable to neighboring Asian countries.
Two, they’re now able to because China – the world’s largest exporter and thus the benchmark setter for the price of many exportable goods – is allowing the yuan to appreciate. By making Chinese exports more expensive, other countries are now more comfortable with making their own currencies and exports more expensive.
Three, there is a brewing race among emerging market countries to dump US dollar-denominated assets from their foreign exchange reserves.
This is a classic scenario in financial markets in which multiple parties want to get out of the same asset and no one wants to be left holding the bag after everyone else has already sold out.
Emerging markets central banks, therefore, are selling as much US dollars as China’s yuan appreciation would allow them to.
Borthwick explains that March 31’s accelerated pace of emerging market currency appreciation was sparked by the decision to leave Japan out of the equation.
Previously, Japan – itself a large exporter – held back the pace of non-dollar currency appreciation because it has no inflation and thus no desire to appreciate the yen.
Now, in light of the devastating earthquake and ongoing nuclear crisis, it was decided that Japanese exports longer posed such a big threat to emerging market countries, thus paving the way for these countries to accelerate their pace of currency appreciation.
As the US dollar depreciates against these emerging market currencies, it’s also expected to depreciate against G10 currencies like the euro, pound sterling, Australian dollar, etc., according to Borthwick.
Previously, emerging markets central banks constantly bought the US dollar in order to keep their own currencies down. Now, as their currencies appreciate against the dollar, this kind of support for the dollar will shrink, said Borthwick.
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