Rumblings of discontent from leaders of emerging market economies around the middle of last year when it looked as though the US was about to commence tapering quantitative easing. These rumblings are likely to get a whole lot louder this time around though, as the impact of US policy starts to bite these economies hard – see the following commentary courtesy of Ozforex.

The possibility of a Global Emerging Currency (GEC) crisis has grown over the last week with emerging market currencies around the globe such as the Argentine Peso (-5%), South African Rand (-3.6%) and the Indian Rupee (-2.2%) sold heavily in the last week alone. If it continues, as I think it may, then undoubtedly the Australian economy and the Aussie dollar will also be affected.

What’s different this time around?

What strikes me about the recent price action is that unlike previous emerging currency crises, think Latin America in the ‘80s or Asian Currencies during the late ‘90s, the selling does not appear to be geographically specific. This is not just an issue for South America or some parts of Asia, as we have also seen currencies in Europe like the Russian Rouble (-2.6%) and Turkish Lira (-4%) weaken.

This time around the catalyst is coming from one global external source and as such it has the ability to reach all four corners of the globe.

It’s not all down to US QE tapering though. There are some country specific economic factors (e.g. widening deficits or political uncertainty) contributing to the performance of each economy but the markets seem to be driven more by fear at the moment.

What does this mean for the Aussie dollar?

Our currency has long been linked to a phenomenon termed “risk appetite”. In short it could be described as an investor’s willingness to take on riskier investments. Rightly or wrongly given our reliance on commodity markets, which can be risky investments, the Aussie dollar moves up in a risk “on” environment or down when risk is “off”.

At different times this may exert a varying degree of influence on the Aussie but it is when the link is strongest that the currency moves the most. So when we get big moves in commodity or equity markets or there is some unexpected news, the local currency tends to move wildly in anticipation of investors shifting investment classes.

Last week, on two occasions within 24 hours of each other, we had China Flash PMI disappointing and then China issued an alert on credit risks in the coal industry. This sparked “risk off” environments and the Aussie dollar fell 2% in less than 2 days against the greenback. Comments from RBA member Ridout about a lower Aussie added to the sell-off, but the point here is that when the markets are in a risk off mood the currency falls quickly.

In the case of a GEC crisis where risk is off we see a flow of funds back to the US dollar, supposedly because it’s a safer store of value given its reserve currency status. Money from all over the world flowing back into greenback denominated assets serves to strengthen the USD, not only weakening emerging currencies but keeping a lid on the AUD as a consequence.

Will it continue?

In what can be described as a continuous loop, a falling currency can have a negative effect on the economy which in turn adds to further selling of the currency. And so the cycle continues, rather quickly I might add, until something happens to break the cycle. It will take some narrowing of deficits, political stability and perhaps a little ironically, a stalling US economy to stem the flow out of some emerging markets.

As the markets have only just begun to show signs of fear I believe the cycle could be in the early stages of something that lasts quite a while longer.

Source : Jim Vrondas is Chief Currency strategist, Asia-Pacific at OzForex, a global provider of online international payment services and a key provider of forex news. OzForex Group Ltd is a publicly listed entity with shares traded on the Australian Securities Exchange under the code “OFX”.