USD CAD/ CAS and EM relationship

Let's break down how USD liquidity flows are influenced by the US Current Account Deficit (CAD) and the US Federal Reserve's monetary stance, especially concerning Emerging Markets (EMs).

1) US Current Account Deficit (CAD) and USD Flows:

* EMs Earn USD through Exports: When EMs export goods and services to the US, they receive payment in US dollars. This is a direct inflow of USD into the EM economies.

* CAD Reflects Net Outflow: The US CAD signifies that the US is importing more than it is exporting. This implies a net outflow of USD from the US to its trading partners, including EMs.

* Increased USD Liquidity in EMs: A larger US CAD generally means that EMs are accumulating more USD through their trade surpluses with the US. This increases the supply of USD within their financial systems, contributing to USD liquidity in those markets.

* Demand for EM Assets: The USD earned by EMs can then be used to invest in their own economies or financial assets. This increased demand for EM assets, fueled by USD earnings, can further support liquidity in those markets.

In essence, a US CAD driven by strong EM exports to the US leads to a flow of USD from the US to EMs, boosting USD liquidity within EM economies.

2) US Fed's Monetary Stance and USD Flows:

* Monetary Policy Tools: The US Federal Reserve (the Fed) uses various tools, primarily interest rate adjustments and quantitative easing/tightening, to influence the supply of USD and credit conditions in the US.

* Impact on Borrowing Costs: When the Fed adopts an accommodative (loose) monetary policy, characterized by lower interest rates, it becomes cheaper for entities globally, including EMs, to borrow USD.

* USD Borrowing by EMs: EMs, whether governments or corporations, often borrow in USD due to its status as the global reserve currency and the depth of US financial markets. Lower USD borrowing costs encourage them to take on more USD-denominated debt.

* Increased USD Liquidity (through borrowing): This borrowing activity injects USD into the EM financial systems, increasing USD liquidity. The borrowed funds can be used for various purposes, such as funding domestic investments, trade finance, or managing existing debt.

* Tightening Monetary Policy: Conversely, when the Fed tightens monetary policy by raising interest rates, USD borrowing becomes more expensive. This can reduce the incentive for EMs to borrow USD, potentially leading to a decrease in USD liquidity flows to these economies through this channel. It can also make it more challenging for EMs to service their existing USD-denominated debt.

Therefore, the US Fed's monetary stance significantly shapes USD liquidity flows to EMs by influencing the cost and availability of USD borrowing.

Interaction between the Two:

It's important to note that these two factors can interact and sometimes have offsetting effects:

* Strong EM Exports and Tight US Monetary Policy: Even if EMs are earning a significant amount of USD through exports to the US (large US CAD), a tight monetary policy by the Fed could still make it more expensive for them to access additional USD through borrowing.

* Weak EM Exports and Loose US Monetary Policy: Conversely, even if EM exports to the US are weak (small US CAD), a loose US monetary policy with low interest rates could still encourage USD borrowing by EMs, providing some USD liquidity.

In conclusion, USD liquidity flows to Emerging Markets are a result of a complex interplay between the USD earned through trade with the US (reflected in the US CAD) and the cost and availability of USD borrowing, which is heavily influenced by the US Federal Reserve's monetary policy stance. Both channels are crucial in understanding the dynamics of USD liquidity in the global financial system and its impact on EMs.

Source: Different websites