The dollar is still a currency you run to …

At least if you have borrowed dollars to buy stocks in emerging economies that are tanking.

The series of crisis that rocked emerging economies in the 1990s were a formative experience for me.   So Monday’s big sell-offs has a rather familiar feel.  It sure seems like investors are running from all emerging economies, no matter what their vulnerabilities.     

I can understand running out of Turkey’s 2008 lira bond.  Those who bought it were betting the lira would be stable and Turkish inflation would continue to converge toward European levels.    Neither assumption panned out so far this year.   Turkey’s fiscal and current account deficits also look to be bigger than expected.  But Indonesia isn’t Turkey, and it too sold off.

And for a country like Brazil, the swing in sentiment was swift.   Brazil’s central bank was adding to reserves big-time in the first half of May (reserves grew by $7 billion between the end of April and May 15.  A few days ago real was close to 2.05; today it came close to 2.30 – what flowed in, flowed out.   Talk about sudden stops

Tuesday has been a bit different.  With oil prices still high, investors moved back into Russia. 

Those who argued that in the new post-crisis world, emerging markets were no longer correlated but rather traded on their individual merits may need to reevaluate just a bit.   The money sort of flowed in everywhere earlier in the year, and right now it seems to be flowing out everywhere.  It sure feels like a large set of creditors is reevaluating emerging market risk in mass – as the one factor that links the country’s that have sold off is that they attracted flows from the same set of people.   The FT on Monday's moves:

The MSCI emerging markets index was on track for a 10th consecutive decline, its worst run since August 1998, when the Russian default triggered worldwide market turmoil.

Dealing in Indian stocks was suspended on Monday after the main index slumped 10 per cent in early trade. After a pause to calm the market, trading resumed and the benchmark index ended down 4.2 per cent. 

Russian equities fell 9.1 per cent, the Turkish market dropped 8.3 per cent and Brazil  … was down 4.5 per cent in midday trade.

Gerry Fowler, a strategist at Citigroup, said: “There is now higher demand for hedging – people are expressing more genuine concern that the liquidity crunch is not yet over. Last week, people were thinking that the sell-off would be short-lived.

At the same time, there are huge differences between emerging markets today and emerging markets in the past.  Setting emerging Europe (including Turkey) and India aside, most emerging economies had current account surpluses, not big deficits.   Big inflows were financing reserve accumulation – not deficits.   And countries with deficits generally were getting more flows than they needed to cover their deficits.  Look at the growth in Turkey’s reserves from 2004 on.    

Prices have corrected, but from very, very high levels.    I remember when the EMBI spread was well over 600bp a lot of the time; a spread of 223 bp hardly seems shocking.    Emerging market equities had risen to very high levels indeed.    A couple of analogies:  Oil at $70 is still rather high, even it isn’t $73.   And a reading of 20 for the VIX was pretty normal not all that long ago – even it that is a lot higher than 10 and its 8 point rise this year must be quite painful to some.   Remember, the VIX index hit 45 after Russia. 

One thing still seems constant:  in times of trouble in emerging economies the US still acted a safe have.   Treasuries have rallied.  The dollar isn’t under the kind of pressure it was under two weeks ago.

To me, at least, there is still something a bit strange about selling the currency of a country with a large current account surplus for the safety of the currency of a country with a very large current account deficit.  True, some surplus countries – like Brazil – don’t look that hot in other ways, at least not during the harsh light of a global correction.    But as Nouriel likes to remind everyone, the US has many of the same vulnerabilities as emerging economies like Turkey – or advanced economies like Iceland.

Best I can tell, though, those fleeing emerging economies for the safety of the US are largely US and other dollar based investors – not the citizens of emerging economies.   Those who borrowed dollars to buy emerging market risk have a particular need for dollars.   They are in a slightly different position that say investors in emerging economies who have in the past looked to the dollar as an alternative to their own shaky currencies.  Like some others, I doubt that the unwinding of positions in emerging economies that originated in the US can provide an enduring base of support for the dollar.

Let me try to explain why with a bit of data.

In 2005, the “non-oil exporting” emerging economies – counting Latin America as a non-oil exporting region along with East Asia and Eastern Europe – ran a currnet account surplus of $122b.   Eastern Europe ran a deficit of $63b; Latin America and Asia ran a surplus of $185b (mostly because of China).

These countries also attracted $203 billion in private capital flows.   Much of that was FDI, but, according to the IMF, $79b was “portfolio flows” of various kinds – portfolio flows that bid up the price of (thin) local stock markets the world over.

The current account surplus and private flows combined to finance $302 billion in reserve growth (these numbers aren’t adjustd for valuation, so they are off in a few important ways, but the adjustments needed are complicated; actual reserve accumulation was substantially higher, which implies that capital inflows of various kinds were a bit higher) and $10b in net payments to official creditors.

In broad terms, the money that flowed into the stock markets (and local currency debt markets) of emerging economies flowed back into German bunds and US Treasuries, as emerging economies used the inflows to build up their reserves.   And if investors sell their emerging market equities and flee to the safe haven of Treasuries and bunds, nothing much changes.    Reserve accumulation goes down, but that just reflects smaller inflows.  The net flow doesn't change much.  Money that was previously going into Treasuries through an emerging economies central bank now goes directly to the Treasury market.

There only is a big impact on the overall pattern of global capital flows if the portfolio preferences of the private investors who used to love emerging economies differ dramatically from the portfolio preferences of central banks.   Ted Truman drilled this point into my head; he usually is right.  And during a flight to safety, private investors presumably have the same preferences as central banks, not different ones.

The interesting question – at least for me – is what happens once the dash for safety ends.   Where does the money that got out go?

And where does the oil money that was chasing yield in emerging economies go?   

Home?  To the US? Or to the Euro?   Russia, lest we forget, added another $5b to its reserves in the second week of May.  Russia and Saudi Arabia aren’t short of cash with hovering around $70.