Nouriel and I postulated back in early 2005 that there was a meaningful risk that the next “emerging market” crisis might come from the US – and it might come sooner than most expected. The basic quite simple: Ferguson’s debtlodocus might find that it no longer could place its debt with the world’s central banks, the dollar would fall, market interest rates would rise, US debt servicing costs would go up, the economy would slow and the value of a host of financial assets would tumble.
Why the emphasis on central banks? Simple: they have been the lender of last resort for the US, financing the US when private markets don’t want to. See April 2006. Consequently, a truly bad scenario for the US seemed to require a change in central banks’ policies. Real emerging markets aren’t so lucky. When private markets don’t want to finance them, they typically aren’t bailed by someone else’s central bank.
It sure doesn't look like sudden stops in financial flows and sharp markets moves have been banished from the international financial system. Certainly not this year. They just didn't strike the US, but other countries with large and rising current account deficits.
Iceland’s currency is way down (its stock market too) even though interest rates on Icelandic krona are up. The private market’s appetite for krona disappeared.
Inflation is up too, driven by the weak krona.
Turkey's central bank sold dollars this week -- for the first time in quite some time. It was buying dollars in a big way in the first quarter. Times change.
Currency collapses do not necessarily translate into economic slumps. That was a key point that the Federal Reserve has made in response to fears about a US hard landing. A fall in the currency doesn’t always translate into higher interest rates, at least in post-industrial countries. And in part because lots of the damage from a fall in the currency comes when firms, banks and the government have borrowed in foreign currency, turning a currency crisis into a debt crisis.
The US, thankfully, has financed itself by selling dollar-denominated debt, pushing currency risks onto its creditors. But so did Iceland. And even Turkey increasingly financed itself in Turkish lira. Particularly in 2005, there were big inflows into Turkey’s local debt and equity markets. Turkey obviously still has a fair amount of dollar debt. It is an emerging market after all. But things were changing.
I still think the financial slump in both Iceland and Turkey could easily turn into a sharp economic slump. In both countries, both policy and market interest rates are up significantly – in part because a weaker currency (and still strong oil) translates into higher prices for imported goods. And I suspect higher interest will, over time, slow the pace of both economies’ expansion.
One big reason why Turkey was growing fast was that because its banks were lending tons of money to Turkey’s households, whether to buy a car or buy a house. But it only makes sense to lend long-term at 13% (say for a mortgage) if inflation and nominal interest rates are expected to fall over time. This year, both inflation and nominal rates rose. Ouch (if you are a bank).
I suspect that the result will be a significant slowdown in credit growth – and in the Turkish economy.
Charles Gottlieb of the European Capital Markets Institute notes that Iceland too was growing in part on the back of a strong expansion of credit (see his figure 1) – though in Iceland’s case, demand for Icelandic Krona was for a while so long strong that Icelandic issuance alone couldn’t meet it. Consequently, European banks started issuing so called Glacier bonds in krona (a note: I am sure the banks hedged their krona exposure, I just don’t know how).
And Gottlieb nicely shows what a sudden stop looks like. See his Figure 4. It shows a huge surge foreign purchases of Icelandic securities issued by Icelandic residents (I think that means it excludes Glacier bonds) up until January of this year. And then a huge – and I mean huge – fall. Inflows became outflows. Foreigners sold; Icelanders bought.
I am not convinced Iceland is the next Thailand – but there are lots of unpleasant outcomes that aren’t quite that severe.
Turkey and Iceland are not the only markets who went through a rather nasty sell-off. Emerging market equities just has their worst run since 1998. Of course, it comes after a huge run-up. And as no shortage of credible observers – like Ragu Rajan of the IMF -- have noted, the markets that are selling off the most are the markets that rose the most. That suggests that the causes of the sell-off are global, a change in the markets willingness to invest in emerging economies, not local – that is what the generally bearish BIS thinks and in this case they have support from some (former?) bulls, like MSDW’s Turkey analyst Serhan Cevik.
Despite this indiscriminate sell-off, there is still no agreement among investors as to what the sudden burst of global volatility actually reflects. …. Risk reduction always brings indiscriminate selling of all ‘risky’ assets at the early stages, regardless of underlying economic structures and policy frameworks.
The team at Danske bank hasn't been as consistently bullish at Cevik, but they seems to agree that it is hard to pin down any fundamental cause of the recent sell-off.
I certainly didn’t see this kind of global sell off of emerging economies coming, though I worried about a few specific markets. And not just ex post. But then again I am usually good for a cautionary quote …
And in some sense, the fact that the current global sell-off focused on emerging economies is a bit strange. I see the logic: what went up too fast has to come down.
But the defining characteristic of the recent boom in private capital flows to emerging economies is that, at least in aggregate, capital was flowing into emerging economies didn’t need the money. The US was attracting more financing that it needed to run very large deficits, and using some of the money to invest in emerging economies. And emerging economies were taking financial flows from say Europe and using them to lend to the US. It was a rather complex equilibrium.
Look at the statistical data in the latest issue of the World Bank’s (very useful) Global Development Finance. Developing economies collectively ran a current account surplus of $245 billion in 2005. Private inflows of $490 billion were used to pay back the IMF and to build up reserves -- these countries reserves were up by $395b or so in dollar terms, more than their current account surplus.
(One note for true balance of payments geeks: the GDF’s reserve increase isn’t adjusted for valuation changes. If you make that adjustment, total reserve growth would be bigger, and the errors and other flows term would fall)
Of course, what happens in aggregate can mask big differences in the specifics. China, Saudi Arabia and Russia all had big current account surpluses. Brazil a more modest surplus. India had a small and growing deficit. Turkey – and Hungary -- had big deficits.
Despite these differences the equity markets of Russia, Brazil and Turkey have all tumbled this year. Foreign funds that poured into these economies earlier this year poured out in May. When the data comes in, the change will look a bit like Gottlieb’s graph showing flows in and out of Iceland.
My hypothesis therefore is twofold:
The recent correction has been driven as much by developments inside the financial markets of the post-industrial economies as by a change in the emerging economies themselves. Hence the general sell-off.
And the impact of the correction will vary dramatically. Some countries didn’t need inflows. Russia. Others did. Turkey. But even in turkey, the inflows that were coming in far exceeded what Turkey needed. In the first quarter, annualized inflows were something like $60b relative to a current account deficit of $30b. If flows go to $30 or $25 Turkey is fine. If they go to zero, not so much.
Actually, my hypothesis is threefold.
In April, the G-7 communique triggered a fall in the market’s willingness to finance US deficits. We saw that in the TIC data. There also was a bit of a surge in capital inflows to Asia that prompted a bout of intervention. Central banks financed the US when markets didn't want to.
In May and early June, folks who borrowed dollars and yen to buy emerging market equities (and debt, to a lesser degree) sold their emerging market equities and repaid their loans. Call it deleveraging.
The net effect has been to help finance the US. Less money was flowing out of the US – US purchases of foreign equities averaged about $10b a month for the first four months of the year. And if Americans may have actually reduced their exposure to emerging economies in May and June. That too would help to finance the US deficit. Deficits can be financed by selling (external) assets as well as issuing (external) debt.
My question: What happens once this process is over?
Do higher US rates continue to draw the financing the US needs to run big current account deficits – a deficit that I still think will be over $900b?
In part because China and the oil exporters continue to use their central banks and oil investment funds to finance the US?
Or does the US join the list of high-carry (at least relative to Japan and Europe) countries that have experienced trouble in 2006?
And what happens if an incipient US slowdown start to generate expectations that US rates have peaked and won’t provide as much support for the dollar?
If I had to guess, I would say Bill Gross (quoted in Business Week) is right.
It's like Peter Pan who shouts, "'Do you believe?' And the crowd shouts back, in unison, 'We believe.'" You can believe in fairy tales and Peter Pan as long as the crowd shouts back, "we believe." That's what the dollar represents, a store of value that people believe in. They can keep on believing, but there comes a point that they don't.
Greenspan was here two months ago and talked with us for two hours. The most interesting point was his comment that there will come a time when foreign central banks and foreign investors reach saturation levels with their dollar holdings, and so he sort of drew his hand across his neck as if they've had it. Why can't they keep on swallowing dollars? Logic would suggest that these things start to fray at the fringes. Once the snowball starts it can really get going. ...
The dollar is really well supported by its yield. We've got 5% overnight rates and Japan has zero. You get over 2% relative to the euro, so obviously 5% or 5.25% is dollar-supportive, and the more that Bernanke sounds off that he's going even higher, the more that supports the dollar. The real question is what starts it on the way down? At the moment people believe that's O.K. and yes, housing is starting down, but the rest of the economy is looking good, 2% to 3% GDP growth isn't so bad. I would say that if that's the case we've got a pretty good little fairy tale going here. But if it doesn't, if 5% leads to a crack in the housing market and the unwind of various global markets and the U.S. stock market ... If the stock market keeps going down then that's a sign that 5.25% is too onerous a rate. So what the question becomes then is can the U.S. economy be supported at that level? That's when the question of whether there's the possibility of an avalanche begins. If we get rates then down to 4.5% and then all of a sudden the [other central bankers] are moving up, the money flows out. It's not because of the [lack of a] yield advantage; they've had it up to their necks in terms of dollars. The unwind of the dollar can come from saturation or geopolitical issues or simply that the U.S. economy isn't as strong as people think and they stop believing in Tinkerbelle.
A big fall in the dollar isn’t bad for the US. A big fall in financial inflows that led to a rise in US interest rates though is another story. A 200 bp move is not so big for emerging economies, but it is big for the US. And because the US financial system is much more leveraged, it would also have much bigger consequences.