Every coin has two sides and the impending Federal Reserve (Fed) tightening cycle appears no different.
The potential negative impact of the central bank’s planned interest rate hikes on the emerging market (EM) paper currencies may perhaps compensate for an expected drop in the U.S. demand for perceived store of value assets like bitcoin and gold.
“Cryptocurrencies and stablecoins are good alternatives during depreciation,” Mark Thornton, senior fellow at Ludwig von Mises Institute, told CoinDesk in an Email. “I also think gold and silver are good alternatives at the moment, particularly in EMs.”
“Toggling back and forth between cryptocurrencies and precious metals provides balance and greater upside for that segment of an individual’s portfolio,” Thornton added.
An emerging market economy is a developing nation in the process of becoming more industrialized and connected with the global economy. India, Mexico, Russia, Saudi Arabia, China and Brazil are notable emerging market economies.
Currency depreciation or devaluation refers to a fall in the value of the home currency in terms of its exchange rate versus other currencies. Depreciation is inherently inflationary as a weaker currency boosts import costs and often has local investors scrambling to buy alternative assets with a store of value appeal such as gold and bitcoin.
Bitcoin has found increased demand from Russia and Ukraine as Moscow’s decision to invade Ukraine has sent the Russian ruble crashing and led to significant disruptions in Ukraine’s currency markets. Gold also rallied to an 18-month high of $1,974 last week.
Some traditional market observers have been worried about a potential slide or depreciation of emerging market currencies against the U.S. dollar ever since the Fed took a sharp hawkish turn in November, hinting at several interest rate hikes in 2022.
That’s because interest rate differential is one of the significant factors influencing exchange rates. When a dominant country like the U.S. signals rate hikes, emerging markets with relatively higher rates but significantly smaller economies see capital outflows. That exerts downward pressure on the EM currencies and pushes the dollar higher.
“Exchange rates against the U.S. dollar have held up for most emerging markets (EMs) in recent months, but there remains a risk that more could face significant depreciation pressure in 2022, particularly if the pace of monetary tightening in the U.S. accelerates,” Fitch Ratings said last month.
EM investors could diversify into bitcoin and gold if the Fed tightening triggers a sharp reversal of capital inflows, leading to an exchange rate slide. With inflation already elevated worldwide, even a slight currency depreciation could trigger panic buying of gold and bitcoin.
The Fed tightening is a major risk, particularly for currencies of EMs running current account deficits. The deficit occurs when a country sends more money abroad than it receives, leaving the domestic currency vulnerable to increased borrowing costs elsewhere. Thus, countries running current account deficits like Brazil, India, Pakistan may see strong demand for bitcoin.
“Large current account deficits implies greater borrowing from overseas and this puts the local currency at greater risk as people will exchange local currencies for cryptocurrencies, precious metals, and anything real,” Thornton said. “Major economies’ central banks have already printed enough money to create hyperinflation and have borrowed more than enough money to induce hyperinflations. Paper money will fail. It’s only a matter of time.”
EMs may prefer bitcoin over other hard assets
Emerging market investors may flock to bitcoin rather than gold or other hard assets as cryptocurrencies can circumvent government-imposed capital controls.
“One tool emerging markets have used when trying to defend a devaluing currency (or maintain a peg) is to restrict convertibility. The “capital controls” are designed to limit conversion from the emerging market currency to USD. Broadly speaking, these restrictions are not very effective,” Bryan Routledge, associate professor of finance at the Tepper School of Business, Carnegie Mellon, “Presumably, crypto gives one more channel for people to get around capital controls.”
Governments and central banks often impose capital controls to stem the outflow of money from the country to arrest the exchange rate slide. Earlier this week, the Russian central bank raised rates from 9.5% to 20% and ordered exporting companies to sell 80% of their forex revenues in the market. In August 2013, the Reserve Bank of India imposed controls on overseas investments to support the sliding rupee and the government put curbs on gold imports.
EMs can initiate similar steps if their currencies slide in the coming months. However, with their decentralized, peer-to-peer and borderless systems, cryptocurrencies appear insulated from such measures.
Anyone can mine a bitcoin and the cryptocurrency’s blockchain facilitates peer-to-peer transfers between two parties, meaning that intermediaries are no longer required to manage the transaction. In other words, crypto users can bypass traditional banking channels and, in theory, cannot be controlled.
“The existence of cryptocurrencies may expand the options for capital flight, hence perhaps making these situations more difficult, though the capital flight is always difficult to control and there probably aren’t many good regulatory options,” said Michael Englund, principal director and chief economist at Action Economics LLC.