In the years following the outbreak of the Iraq War in 2003 and instability in the Middle East, oil prices globally spiked to record highs of over US$100 per barrel. By 2015, however, prices fell precipitously to below US$40 per barrel as oil production rose and major economies signaled changes in interest rate policies that pumped the brakes on global growth and oil demand. The shift caused a particular turmoil in emerging markets, whose currencies saw volatility and strong pressure to revalue in the face of the new scenario.
Oil: The Critical Link
Currencies of nearly all economies will be strongly affected by fluctuations in the price of oil. But emerging market nations can be especially affected, either because they are large oil producers and exporters, or because of their dependence on oil for development of their economies.
Knock-on Effect On Commodities Prices
When the price of oil moves, traders note that the prices of other important commodities move as well. This is because the price of oil has a direct impact on the cost of fuel for transportation around the world. Prices of key agricultural commodities such as soybeans, corn and wheat are highly sensitive to oil price changes. Prices of metals such as iron ore, aluminum and copper are also quickly affected when oil prices change. As a result, the currencies of countries that are heavily dependent on either the use or export of these commodities are also quickly affected when oil prices change.
Vulnerability In Emerging Markets
Countries that can be especially affected by oil price variations include some of the major emerging market nations that serve as the driving economic motors of the regions where they are located. Among these are the so-called "BRICS," including Brazil, Russia, India, China and South Africa.
Traditionally, Brazil was a net importer of oil, and its domestic prices and economic activity could be strongly affected by international oil price fluctuations. However, in 2007 the country made discoveries of large offshore oil reserves, and since then has become a small net exporter of oil. Oil accounts for about 7% of the country's total exports. However, production of the reserves, which are deep beneath pre-salt geologic layers, has only been considered viable when international oil prices are above US$45 per barrel. Thus, a steep decline in oil prices can have a negative impact on Brazil's export capacity and contribute to a generally weaker level for the country's currency, the Brazilian real.
Russia has long been considered a large-scale oil producer, with heavy domestic production dating to the early 20th century. The government estimates that if oil stays in a range below US$50 per barrel, the country can be subject to declining economic growth. Russia's trade balance is also heavily dependent on oil, which represents more than 60% of the country's total exports. Considering this dependence, the Russian ruble is likely to remain weak when oil prices are low.
Read more about how the price of oil affects the Russian economy.
India is the fourth-largest consumer of oil and a heavy consumer of imported oil. As such, the country stands to benefit whenever the global price of oil declines. In particular, price declines ease local inflation and help diminish the current account deficit. These factors can be helpful in strengthening the country's currency, the rupee. India, however, exports its goods to many oil-producing countries, so a prolonged period of low oil prices can ultimately have a negative impact on exports and GDP growth.
China is one of the world's largest net importers of oil, and thus stands to benefit from lower global crude prices. Crude oil accounts for more than 10% of the country's total imports, and low prices help boost the country's current account surplus and growth of the GDP. These factors would normally help contribute to the strength of the Chinese currency, the yuan. However, falling fuel prices have also contributed to deflationary pressure in the Chinese economy, bringing a slowing of growth and helping undermine the strength of the yuan.
South Africa is a net importer of oil, so the country can benefit when oil prices decline. A lower cost of fuel can help lower transportation costs, bringing a beneficial impact on food and consumer goods prices, and helping cut inflation. Oil accounts for more than 15% of South Africa's total imports, and thus any decline in oil prices can be expected to have a positive influence on the strength of the country's currency, the rand.
As with the currencies of the larger countries, currencies of smaller emerging market nations can see similar effects depending on their relative vulnerability to oil and other commodity price shocks. Because of regional trade links, the fortunes of BRICS nations themselves can directly affect their neighbors.
Currencies from countries such as Chile and Argentina, for example, are strongly affected when there are sizable fluctuations in the Brazilian real, while the currencies of Armenia, Georgia and Kazakhstan can be strongly affected by changes in the ruble.
An often undesirable economic phenomenon known as "Dutch disease" can occur when countries have too much of a particular commodity to export. This is common when countries discover windfall oil supplies. When this takes place, the heavy exports of a single commodity end up bringing in more foreign money and strengthening the country's currency. The strong local currency subsequently makes the country's other exports, such as manufactured goods, more expensive and harder to sell abroad, thus weakening local industry.
This phenomenon was first identified in Holland after the discovery and export of large natural gas reserves in the 1950s and 1960s. Hence the term, Dutch disease.
Sovereign Wealth Funds
To combat Dutch disease and the unintentional strengthening of local currencies, the governments of many countries that are large producers of oil or other commodities have formed sovereign wealth funds. Using these funds, they put money obtained from oil exports or other sources into local and foreign investments, so that their economies are not awash in foreign cash that will make their currencies significantly stronger. Countries with large sovereign wealth funds include Saudi Arabia, United Arab Emirates, Norway and China.
Oil is a key component in the economies of both developed and emerging market nations. Variations in oil prices, however, may bring particularly strong effects in emerging market economies. They often have shallower domestic market competition in addition to higher dependence on imports and production of basic commodities.
The transmission mechanisms for oil price variations to local economies and currencies include transportation, raw materials costs, current account balances and inflation. Increases and decreases in global oil prices will have different impacts on differing emerging markets, but sharp variations in either direction have been found to contribute to volatility of currencies of oil dependent and oil exporting nations alike.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…