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04 October 2023

Currency revaluation to ease overheating

By Nitin Nambiar



A further decline in the US dollar would aggravate overheating phenomenon in emerging markets. It will affect the dollar-pegged currencies the most, ratings agency Moody’s Investors Service has said.


The UAE and Qatar economies are already showing signs of overheating. This could be eased if the countries opt for a currency revaluation, said a report released by Moody’s on Tuesday.


“As with some Asian countries, the US dollar pegs lead to imported inflation and an ongoing accumulation of foreign exchange reserves, and have come under considerable strain recently,” Moody’s said in the report.


“It is obvious that booming oil and gas prices, combined with US dollar pegs, impede effective macroeconomic management. That said, the macroeconomic challenges that the GCC countries currently face hinge considerably on their large expansion in government spending.”


According to the ratings agency, a sharp US dollar decline would probably force some GCC countries – most likely the UAE and possibly Qatar – to follow Kuwait’s example of letting their currencies appreciate against the US dollar. A shift to a basket of currencies against which the countries’ own currencies are pegged is not ruled out either.


But a loosening of the US dollar pegs, according to Moody’s, would probably be gradual, since for most countries in this group there are compelling political reasons to maintain some kind of link to the US dollar.


According to Moody’s, a further depreciation of the US dollar would likely be a “positive sum game” for global sovereign ratings.


In the case of emerging market economies with overheating phenomena, as long as the US dollar decline takes place in an orderly manner and the policy responses by the individual countries are appropriate, “rating implications would, ceteris paribus, be very marginal”, according to Moody’s.


In the case of China, however, the effect could even be mildly positive. The current rating issues for GCC countries are quite remote from the prospect of overheating, Moody’s said.


Upward pressure


“Looking at the sovereign universe as a whole, a further significant depreciation of the dollar would be mostly positive as the developed countries’ ratings would not be affected much. Several emerging market countries’ ratings could even experience some upward pressure,” said Moody’s Vice-President Dietmar Hornung, who authored the report.


“However, the extent to which such an event is credit positive globally is critically dependent on whether the depreciation is orderly or precipitated. A fully-fledged dollar crisis would clearly be negative for many countries,” Hornung said.


The effect of a dollar decline would be favourable for countries with a sizeable portion of their debt stocks in either US dollar-denominated or dollar-linked instruments, as it would improve their debt metrics, according to Moody’s.


However, other countries would experience a “loss”, since the appreciation of the local currency would lead to a decrease in the local value of foreign exchange reserves.


Countries with euro-linked currencies would be hit by a loss in competitiveness, and dollar-pegged economies’ overheating problems would be worsened by the additional macroeconomic stimulus.


“Country-specific challenges may be aggravated by the fact that a severe US dollar depreciation may deflect – and even reverse – financial flows in world capital and asset markets,” Moody’s said in the report.


Original sin


The report said emerging economies could be absolved of their “original sin” of borrowing money in foreign currency – often in US dollars – as result of the dollar decline. Such economies could see their external debt transformed into a “virtue”, having shrunk in terms of the local currency as their currencies appreciate against the US dollar.


For emerging economies with sizeable dollar-denominated debt, the possible rating impact would be positive. “The beneficial effect of a dollar decline is important since its impact applies not only to debt stock ratios, but also to debt service requirements,” the report said.


“Some emerging markets may benefit from an orderly US dollar decline [no outright crash] as investment flows into emerging markets’ financial and even fixed assets could increase with global investors cutting their exposure to dollar-denominated assets.”


From a rating perspective, a sharp rise in an emerging economy’s currency against the dollar would not necessarily be a credit positive, according to the report. “The effect of the rise would depend on whether the country uses the weak dollar period to ‘lock in’ a reduction in the debt burden,” it said.


As for the United States, as long as the dollar decline is orderly, according to Moody’s, it would be a net positive for the US economy, further helping to reduce the large current account deficit, although with potential implications for foreign investment decisions.