Sunday, July 27, 2014

Emerging economies hike rates to defend currencies

January 29. 2014 10:37AM
Associated Press

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(AP) It's proving contagious.

First it was the central bank of India. A day later, on Wednesday, its counterparts in Turkey and South Africa followed suit in raising interest rates. But any hopes they had in supporting their currencies were dashed as markets continued to fall.

Currencies in emerging economies have been battered in recent days by a number of factors, including concern over global growth and the U.S. Federal Reserve's decision to rein in its money-creating stimulus.

A lower currency has the potential to stoke inflation by raising import prices controlling inflation is the primary responsibility of central banks around the world.

India's central bank got the ball rolling with its surprise decision Tuesday to raise its main interest rate by a quarter of a percentage point to 8 percent. Though it justified the move in terms of keeping a lid on inflation pressures, protecting the rupee is widely considered to have been a key motive.

Those considerations were clearly behind the decisions in Turkey and South Africa. The Central Bank of Turkey said it was raising its main overnight lending rate to 12 percent from 7.75 percent and more than doubling its one-week rate to 10 percent from 4.5 percent.

The bigger than expected increases come in the wake of a sharp slide in the Turkish lira which has hit a record low against the dollar on concerns over global growth, the prospect that a police bribery scandal might destabilize the government, and the change in the monetary policy stance of the Fed.

Turkey, like other emerging economies, has seen an influx of foreign investment over the past few years as the Fed and other central banks have pumped the prime to shore up their economies. Now that the Fed has begun the process of reducing its stimulus, much of that money is expected to be withdrawn.

South Africa's central bank was clear that the falling rand was behind its decision to raise its main interest rate by a half percentage point to 5.50 percent.

"The recent depreciation of the rand, if sustained, will raise significantly the risk to the inflation outlook," it said in a statement laying out the reasoning behind its rate hike. "Our inflation forecast shows a marked deterioration, despite the absence of clear evidence of domestic demand pressures."

The motivation seems clear enough, but will it work?

Some analysts are skeptical that higher interest rates will be enough to stem the volatility and point to the past to suggest that the endeavor will fail.

"The history of using interest rates to defend a currency usually ends in tears," said Neil MacKinnon, global macro strategist at VTB Capital.

And if one day's reaction in the markets is anything to go by, the jury will likely stay out for a while.

Despite an early lift higher, the Turkish lira is struggling again, down 4.1 percent on the day against the dollar at 2.27 lira. Meanwhile, the South African rand was down 3 percent at $0.0888.

Associated Press

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