The dollar has appreciated by nearly 6 per cent in trade-weighted terms since mid-April, while capital flows to emerging markets have slowed. Although only a moderate further appreciation of the dollar is expected, the US Federal Reserve’s balance sheet shrinking may have further implications for external financing conditions in emerging markets. A report by the Moody’s analyses the vulnerability of a group of emerging markets to a strengthening dollar and tightening external financing conditions in general.

Economies rely on capital inflows to meet import payments and repay external debt. When risk appetite weakens, investors tend to shift their portfolios away from the economies most reliant on such capital inflows, in particular those with low reserve buffers. In turn, lower capital inflows erode foreign exchange reserves, potentially starting a negative feedback loop.

In addition to balance of payments considerations, governments with a large share of foreign currency-denominated debt will see their debt servicing costs increase when the local currency depreciates. When debt affordability is already weak, and reliance on short-term debt high, refinancing a higher debt burden at higher costs exacerbates pressure on the sovereign’s fiscal strength. Moreover, when the central bank needs to raise interest rates in order to mitigate the depreciation of the currency, higher external financing costs spill over into higher domestic financing costs.

In some cases, larger exposures today compared to a few years ago suggest that the structural hurdles to reducing reliance on external financing are high. Doing so now, when external financing tightens is likely to imply significant economic costs, and may raise liquidity risks.

In the report, Moody’s look at the external exposure of 40 emerging and frontier market sovereigns with some of the highest levels of external debt, either in dollar terms or in relation to the size of their economy. It looks at changes in vulnerability to external financing shocks since 2014, a previous episode of tightening financing conditions for a number of emerging markets, to consider the degree of adjustment in external vulnerability in recent years.

Emerging markets that have been prone to large shocks to external financing conditions in the past are, everything else equal, more likely to experience large shocks now unless past shocks triggered adjustments that reduced their reliance on external funding.

In 2014, Hungary, Malaysia, Mongolia and Russia were among those that experienced particularly large shocks to their external financing conditions. In the period since then, Angola (B3 stable), Kenya (B2 stable), Indonesia and Sri Lanka experienced relatively large negative shocks. Of these, Kenya, Mongolia, Sri Lanka and Zambia remain highly vulnerable, implying high structural hurdles to lowering reliance on external financing.