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BBC Capital

Riskology

Emerging markets are wavering. Here’s why it matters.

About the author

Ari has written about financial products and investing for The Wall Street Journal, Forbes, and Pensions & Investments. Find him on Twitter.  

(Thinkstock)

(Thinkstock)

Signs of strengthening recovery from developed economies have sent shudders through emerging markets in recent months, prompting heavy outflows of money from countries spanning the globe from India to China and Brazil.

Emerging market stocks first started to wobble as far back as last spring, when the US Federal Reserve began to discuss its timetable for pulling back on fiscal stimulus, bringing its era of ‘cheap money’ to a close.

But if turbulent stock markets sound like a challenge for people in Ivory Towers or city skyscrapers, think again.

The return of higher long-term interest rates in the US and Europe means marginal money and projects are being pulled-out of emerging market countries and businesses. Investors have been rapidly shifting their investments in favour of what look like tried-and-tested markets.

Stock markets, interest rates and currency exchange rates around the world are all connected and they have a direct impact on your wallet and pay cheque. In short, this interconnectivity all boils down to how businesses grow. Businesses look at the cost of labour and the price of resources when they decide where to build plants and produce goods, as well as what to pay workers. So ultimately, the price you pay for everything from clothes to computers begins to shift as markets, interest rates and currencies fluctuate.

Understanding how global business decisions trickle down to consumers can be challenging, even for the most-sophisticated analysts. Yet it is important for consumer to have a firm grasp on how it all works.

At their most basic, exchange rates indicate the price of one currency against another. Underlying those rates are the costs of goods and services that can be bought in the respective currencies, as well as the cost to borrow that currency, i.e. the interest rate.

The baseline for these rates is generally targeted by central banks – the US Federal Reserve, the Bank of England – and individual and corporate rates are set in reference to that “risk-free” rate. Exchange rates and interest rates adjust daily, based on views of investors and borrowers and which countries/currencies they want to invest in.

To get a clearer picture of the ties that bind global currencies and exchange rates together, BBC Capital spoke to Steven Englander, global head of G10 currency strategy at Citibank. Edited excerpts follow.

BBC Capital: For many of us, our experience with exchange rates occurs only at a foreign bank if we are travelling or sending money to family abroad. There doesn’t seem to be a lot of “exchanging” going on, so what will really move exchange rates?

Englander: It takes a bit of time for the full exchange rate [fluctuation] to really go through into prices [people pay at stores or charge for labour]. In many emerging economies, it moves quicker than in the US, UK and other developed economies. What does happen quickly is the perception that the economy is slowing down and [that] projects are not viable anymore. Economic activity, both corporate and consumer, gets hit very quickly as businesses stall projects [and stop paying workers, cut worker hours or delay buying goods.]

BBC Capital: So how do people under, say, the euro which serves many countries and economies, feel the effects of and adjust to these shocks when the individual countries in the eurozone have little influence over their exchange rate and monetary policy?

Englander: In the eurozone, the adjustment comes by incomes shrinking, which brings down borrowing levels [as business can’t afford to borrow for expansion and hiring.] This process is very painful, because it takes much longer for competitiveness to be restored. In addition, if foreign investors see an extended period of weakness [they are less likely to invest in the area].

BBC Capital: We've been reading a lot recently about emerging markets and the effect of the US Federal Reserve tapering off its bond buying. How are these related?

Englander: The emerging market story is actually threefold. China is slowing and its support for commodity demand is dissipating. [This affects the price of commodities like copper and crude oil and demand for related currencies in Canada and Australia, for example.] The US is beginning to pull rein in bond purchases [which can contribute to long-term interest rates rising.] But some emerging markets responded to global liquidity of the past few years by borrowing more and consuming, rather than investing and implementing structural reform. Now we have a slower China, tighter credit, slower growth and lower commodity prices all happening at once, so countries that were eager to borrow are crunched.

BBC Capital: It sounds like investing broadly in emerging markets and China could be challenging in the short-term. So how should investors view these inevitable fluctuations? Do they need to ‘hedge’ their currency exposure?

Englander: Currency exposure is part of a diversified portfolio and helps reduce portfolio volatility. Many economists and strategists recommend at least 20% to 30% of a portfolio to be exposed to foreign currencies. This can be done by directly owning foreign currencies or through equity investments abroad or companies with significant business outside their home region.

If you hold large US and UK companies — such as those in the Standard & Poor’s 500 index or FTSE 100 — you implicitly have foreign currency exposure. This should also be part of your core financial planning process, understanding how your portfolio and the companies you own are sensitive to individual regions, countries and currencies.