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Alan Ruskin argues that the moves in the foreign exchange market today -- with the dollar and yen rising sharply against nearly everything -- reflect an unwinding of bets made on the assumption that the world economy would remain strong and market volatility would remain low even as the US slowed.
The dollar’s rise since July is part of a reversal in longstanding investment trends that prevailed during years of plentiful borrowing, strong growth and low financial-market volatility. "Essentially, every large trade that built up a head of steam in the go-go years has blown up or is in the process of blowing up," wrote Alan Ruskin, chief international strategist at RBS Greenwich Capital, in a report to clients. "That goes for almost every asset class."
That seems more or less right to me.
Crises have a way of clarifying what happened in the past. I think it is now clear that the scale of emerging market reserve growth from the end of 2006 to q2 2008 should have been a leading indicator that a lot of investors -- probably too many -- were betting that emerging markets (and indeed the world) could continue to grow rapidly even as the US slowed. Reserve growth was running well in excess of the emerging world’s current account surplus, as private capital was flowing into the emerging world in a big way. The IMF data indicates that private flows to the emerging world in 07 and the first part of 08 ($600b a year in 2007 -- over twice the average pace of 04-06; see table A13 of the IMF’s WEO) were well above the levels seen before the 97-98 crisis.
Those capital flows -- plus very low real interest rates, as many emerging markets followed the US rates down even though they were still booming -- helped fuel surprisingly strong global growth even as the US slowed. The US actually wasn’t driving global demand growth over the last two years. Europe and a few booming emerging economies were. The world did decouple. Energy prices certainly decoupled from the trajectory of US demand. But only for a while.
In retrospect, large inflows to the emerging world - and expectations that emerging currencies were generally on an appreciating trend, making it safe to borrow in foreign currencies (or sell insurance against a large depreciation of an emerging market currency) led investors to take on a lot of risk. Consider for example the rise in borrowing from global banks by many emerging markets (documented by my colleagues at the Council’s Center for Geoeconomic Studies) over the past few years. The fuel for the current market fire was there.
I still never would have experienced that the emerging world could experience a sudden stop like it is experiencing now while it was still running a large aggregate current account surplus. Particularly after most emerging markets had built up rather substantial reserves. Both should have helped to buffer against a huge swing in market sentiment, at least in aggregate.
I haven’t done a detailed analysis, but my sense is that the scale and pace of recent market moves -- and in all probability the scale and pace of associated capital flows -- is comparable to the Asian crisis of 97-98.
That is scary.
The leaders of the G-20 countries will have plenty to talk about when they meet in the middle of November.
UPDATE: I added Jim Reid’s line about the "globalization of the credit crunch" to the post’s title after posting it. I like the phrase. Reid is a credit strategist at Deutsche Bank.