A combination of slowing growth, the U.S. Fed’s plan to taper, and other factors are causing a global sell-off of emerging market currencies. So far, currencies around the world have been hit in the sell off, including the Malaysian Ringgit, the South African Rand, the Brazilian Real, and numerous other currencies. While so far the fall-out has been minimal, the potential effects of this sell off could be dramatic.

Emerging Market Currencies

January has already been a rough month for emerging market currencies, with many of them losing value. Through much of 2013 the Indonesian rupiah and Indian rupee were battered, but now it appears that the sell off is spreading to other currencies. Numerous emerging market currencies have taken big hits in the last 24 hours, and for the moment no reprieve is in sight.

The sell-off could be a sign that markets are readjusting themselves to global realities, or it could be the prelude to more serious problems.

Fed tapering likely at play

The emerging market currency sell off should not be all too surprising, given that the U.S. Fed’s tapering plans have been in the mix for months and most analysts believed that it would lead to the dollar rising vs. emerging market currencies. Still, the Fed was hoping that transparency and several months of discussion and planning would soften the impact.

While currencies may be deflating at a rate more stable than they otherwise would have without an announcement by the Fed, the decline has still been notable, taking some off guard. More optimistic outlooks concluded that most foreign currencies had already largely adjusted to the coming tapering, but now it appears that those conclusions were premature.

Indeed, with the U.S. recovery and job market appearing to be on less solid footing than once thought, traders may have been expecting a reprieve from the Fed. Instead, however, the Fed has announced that it will continue with tapering, knocking some $10 billion dollars off of its bond buying program. This should cause the dollar to strengthen further, resulting in declines among foreign currencies.

China slowdown may be exacerbating situation

Following the 2008 financial crisis, China became an engine of growth for many countries as demand from the United States and Europe dried up. A recent contraction in China’s manufacturing sector, in combination with a rather troublesome local debt problem, however, is causing outlooks for China to decline.

It appears that China may be in line for a slowdown in economic growth. Add this into already slowing growth in Brazil, Turkey, and elsewhere and the impacts could be dramatic. When the West faltered it did not drag down the emerging world. Instead, many emerging economies continued to push forward, but now it appears that their luck may have run out.

The factors vary from country to country, but inflation, rising living costs, civic unrest, slowing demand for exports, and numerous other factors are crimping the growth of many countries. And when growth rates drop into the low digits for developing countries, risks begin to increase.

Meanwhile, while the United States is slowly recovering from economic stagnation and the European Union appears to have bottomed out, demand has not picked up. Indeed, with leaders in both countries trying to restructure their economies to be more competitive internationally, it’s possible that declining demand from the West will become a structural challenge, not just part of the business cycle.

Emerging market currency sell-off could lead to more serious problems

In a best case scenario, dropping currency values will spur exports, which will in turn lead to economic growth. This could actually help countries strengthen their economies, and would likely stabilize the currencies themselves.

On the other hand, many companies in emerging markets have been taking out loans denominated in dollars. As their local currencies drop, some companies may find themselves unable to repay their loans. This could actually set off a economic crisis akin to the financial crisis that shook the world economy in 2008.