Many emerging markets have noted the rapid devaluation of their currencies taking place over the past year. In Colombia, the peso is now worth 2,017.01 per U.S. dollar, the weakest currency level since 2009. While other emerging markets such as South Africa and Turkey are fighting incessantly to combat currency declines by raising interest rates, Colombia is taking a different approach by fully embracing the decline of its currency.

Why would Colombia support such low values of currency? This could be due to the inflation rate nearing its lowest level in almost 6 decades. Policymakers believe that the subdued inflation rate and a lessened level of un-hedged foreign exchange positions will allow for the peso’s value to weaken without causing significant damage to the Colombian economy. The low inflation rate is said to be contained by the lower food and gasoline prices in the country. Additionally, the lowered rate helps to gain revenue for exporters of coffee, bananas, and flowers, whose industries had been contracting for the majority of 2013.

For now, Colombia is continuing its 2 year old policy of buying dollars in order to improve its international reserves, which are lower than those of some of its neighboring countries. Colombia’s Central Bank bought $6.8 billion of its currency in auctions in 2013 and has spent $10 million per day so far in 2014. Central bank director José Darío Uribe assured Colombians that there is an “enormous” margin for currency to drop before Colombia’s economy is affected. However, foreign investors are becoming apprehensive about lending their money to the country’s industries seeing as the Central Bank is the sole buyer of the currency. While exporters are benefitting by being able to sell their goods and services at higher prices in other countries, those investing in Colombia are losing money, particularly in the sovereign bond market.

In South Africa and Turkey, currency values are depreciating so quickly that interest rate increases are imminent. Turkey hiked its short-term interest rate drastically from 4.5% to 10% whereas South Africa sought out a smaller increase from 5 to 5.5%. The purpose of these interest rates is to keep “hot money” from flowing out of the domestic bond, equity, and currency markets.  The term hot money refers to money flowing regularly between financial markets while investors try to achieve the highest short-term rates possible. It is possible that these financial transfers could negatively impact the exchange rates if the sum is high enough to affect the balance of payments.

South Africa alone faces the situation of having 40% of its total outstanding stock of debt being held by non-residents, so it is vital to prevent the flow of this money out of its markets. While many consider emerging market countries to be underdeveloped, a stable currency is necessary in order to enable the advancement of financial markets. Even so, the United States Federal Reserve is seen as insensitive in regards to how its policies influence these emerging markets. The World Bank stated in their January Global Economic Prospects report that “The tapering of asset purchases by the Federal Reserve is expected to lead to a rise in base interest rates and spreads”. Because of this, the 100 basis point increase in those countries with high income is likely to see a 110 to 157 basis point increase for developing country yields. This would in response imply an increase in cost of capital and could result in decreased investment and growth for these emerging and frontier countries.

Both policy actions could have negative implications for emerging markets. In countries similar to Colombia in which the Central bank buys its currency, money is often reissued through market operations back to domestic economics. This means that there would be no actual change in the monetary base overall. And although there are risks for countries such as South Africa and Turkey of contracting foreign investment, raising inflation rates could potentially keep money within its own markets and prevent future losses.

One of the key factors that will allow currency to maintain its value is to confirm that when purchasing currency, it is kept out of circulation rather than being reissued back to foreign buyers, a tactic Russia successfully employed with the ruble in 2009. With countries categorized by high inflation rates, interest rates must at a minimum be indexed in order to prevent overall losses in capital of their markets. Another possible solution would be to return to policies that utilize gold as a component of the currency to prevent depreciation. In combination with interest rate hikes, this will enable countries to become less dependent upon the Federal Reserve in the future. To compare more economic aspects of these emerging market countries, please visit globalEDGE's Country Comparator.

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