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EM currencies recover from losses but China slowdown threatens structural slowdown

Emerging market currencies, battered for most of 2023, are expected to take until next year to register substantial gains against a weakening U.S. dollar, despite signals of a potential end to the interest rate cycle.

The recent modest gains in EM currencies followed the Federal Reserve's decision to hold interest rates steady and signs of a slowing U.S. economy.

While a majority of analysts predict a lower dollar by year-end, most EM central banks are likely to cut rates in the coming year, limiting the recovery of currencies from the double-digit losses accumulated in recent years. The Russian rouble and the Turkish lira are exceptions, facing significant depreciations.

Despite the EM currency recovery, FX market gains show divergent medium and longer term trends shaping the economic trajectories of developing economies. In the short term, a pause and eventual reversal of the Fed’s interest rate increases will alleviate capital outflows that have punished EM assets through most of 2023.

In the longer term though, a structural slowdown in Chinese growth highlights how a key engine of EM economic growth is sputtering, lowering overall demand for the emerging world’s key commodity exports and further cutting capital access. Fitch Ratings this week cut its growth forecasts for major EMs, including a significant cut to China's growth potential, with potential structural slowdowns linked to demographic trends, disruptions from the pandemic, and reduced growth potential in key economies.

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