This Wednesday the Bank of Canada (BoC) announced that they would be holding rates steady at 1.5%. Largely influenced by the uncertainty surrounding the NAFTA negotiations, this decision was expected despite the fact that inflation is steadily creeping closer to the 2% target set by the BoC.
While the Governor of the BoC can be a rigourous position, no Governor in the world has had a more difficult summer than the Governor of the Bank of Argentina who was forced to increase rates by 15% in one day from 45% to 60% to stem the flow of money out of his country!!! To put that increase into perspective, if you had a $100,000 mortgage at a variable prime rate, you would now be expected to pay an extra $15,000 in interest this year on top of the $45,000 you were already shelling out!
Obviously this is a move of desperation, but what is causing it and why?
The best explanation is with an example. Let’s say your friend lends you $100,000 US Dollars at no interest on the condition that you pay her back $10,000 per month for the next 10 months. If you live and work in Canada and earn Canadian dollars, the exchange rate between the US and Canada will have a significant impact on how much, or how little, this ‘interest free loan’ will cost you. For example, if the exchange rate does not fluctuate then you can convert your earnings USD and pay her back. However, if the Canadian dollar loses half its value over the repayment period then you will then have to come up with double the amount of money, $20,000 $CAD per month, to make your payment!
Now, apply this example on a global scale where one country is borrowing from all the others in $USD, with interest. Year to date, the Argentine Peso is down over 51%. A country earns most of its income through taxation, which can only be accomplished in their national currency. As the currency devalues relative to $USD, the gap between debt and income increases, leaving Argentina with no real way to pay back this debt!
The only way to attract $USD back into your economy is through direct investment and the best way to attract investors is with sky-high interest rates! Of course, doing so would decimate Argentinian civilians. In speaking with one of my contractors who currently lives in Argentina, she put this succinctly: “Honestly, Argentina is the worst country in the world right now.”
Given the conditions in Venezuela and Turkey at the moment, that is saying a lot!
This same issue applies to many emerging market economies that do not have their economic house in order. Fortunately, The RBC Emerging Markets fund, has steered clear of Argentina and Turkey. Despite the terrible headlines coming out of EM, the fund is only down 3.38% year-to-date. Given its 27%+ year in 2017, one can gladly forgive this moderate pull back.
CBC: Argentina Hikes Rates to 60% - Highest in the world
Globe & Mail: Why it's no time to panic over emerging markets
All Financial data from Morningstar.ca
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