Reverse flows and Emerging markets. By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

April 8, 2015 | Posted by bobbysrinivasan << back to blog

The international monetary fund released data last week which showed that the total foreign currency reserves in emerging and developing economies fell by $ 114 billion year on year in 2014 to 7.74 trillion the first annual decline since 1995 which at the peak hit 8.06 trillion in June 2014. Is it the trend for the future?

In December 2004, the cumulative reserves in the emerging market stood at 1.7 trillion. This became the foundation for emerging market growth for over a decade. Much of the emerging market reserves came from trade surpluses, portfolio inflows, and foreign direct investments. These monies atleast some of it found its way to the US and European debt markets and part of it also was absorbed for finance debt-fuelled growth in developed economies.

The question now is whether the reversal will take place. That will happen if and when the interest rates start moving up in the developed economies. The reverse flow will gain momentum. When this happens currencies of emerging economies will start moving lower against the dollar. Even the relatively small amounts of money moving away from the emerging markets could cause enough panic. In those countries, India, for example saw the rupee dropped to Rs. 68.75 to a dollar before RBI intervention came in.

These are challenging times, the interest rate is kept low in most countries due to deflationary tenderness. Its citizens borrow in local currency convert and invest in the US dollar denominated securities. This is called the carry on trade. Japanese currency and even the Chinese Yuan have been used for the carry on trade. If the out flow from a currency gains momentum due to poor economic fundamentals then such currencies collapse in value. Examples: Euro dropped from 1.39 to a US dollar to 1.05, British pound dropped from 1.73 to 1.47 to a dollar. Brazilian Real dropped 30 percent. Russian Ruble dropped from 32 to 70 a dollar.

Thus we live in a highly uncertain world. The value of our currency is determined in the non-deliverable market. What and when will it happen are all in the speculators hand. Countries which don’t have much foreign debt are the lucky ones. As far as India is concerned we have 330 billion US reserve against which we have 450 billion liability. The next time when the currency outflow takes place there is no telling as to how much the value of rupee could drop. For India’s sake Janet Yellen, postpone increase the discount rate. We don’t need volatility in the value of rupee.

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