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Economic and Political Quagmires
We want to briefly take another look at the situation in four of the emerging market countries that have recently been the focus of considerable market upheaval. The countries concerned are Turkey, Venezuela, Argentina and South Africa. There are considerable differences between these countries. The only thing that unites them is a worrisome trend in their trade and/or current account balances and the recent massive swoon in their currencies as foreign investors have exited their markets (this in turn has pressured the prices of securities). There is currently an economic and political crisis in three of the four countries, with South Africa the sole exception.
However, even South Africa is feeling the heat from the fact that it has a large current account deficit and the ongoing exodus of foreign investors from emerging markets. However, the country is actually used to experiencing vast fluctuations in foreign investment flows in short time periods and has the potential to relatively quickly turn its balance of payments position around. Of the four countries in question, it seems to us to be the most flexible one in this respect.
Argentina and Venezuela
Argentina and Venezuela are special cases in that their trade resp. current account positions are actually comparatively stronger, but the economic policies pursued by their governments are so utterly harebrained and repressive that everybody tries to get their money out as quickly as possible. The immediate problem is that both countries are being drained of foreign exchange reserves at an accelerating clip, inter alia a result of trying to keep their exchange rates artificially high. This is actually quite astonishing considering their considerable latent export prowess.
Both countries have governments that steadfastly deny the existence of economic laws and apparently genuinely believe that their absurd repressive decrees can ‘fix’ their economies. The markets regard Argentina as the slightly greater credit risk, as it is still fighting the so-called ‘hold-outs’ from its 2001 default. However, Venezuela is lately catching up, in spite of its vast oil wealth. The two countries currently have the dubious distinction of being the nations with the highest probability of sovereign debt default in the world – not even the crisis-ridden Ukraine comes remotely close (see chart of CDS spreads further below for details).
We have recently discussed the deteriorating situation in Venezuela in some detail and a more in-depth update on Argentina is in the works. Let us just note here that Argentina (the government of which is incidentally the fiercest supporter of Venezuela’s president Maduro at the moment) seems to be where Venezuela was about a year or so ago. Both countries are on the same path of inflationism and growing economic and financial repression.
Argentina’s balance of trade remains positive – click to enlarge.
Venezuela is a big oil exporter, but needs to import 70% of the consumer goods sold in the country. Its balance of trade is therefore deeply negative, especially as the state-run (‘very, very red’) PDVSA is being run into the ground and produces less and less oil – click to enlarge.
In spite of reporting a positive current account balance, Venezuela is losing foreign exchange reserves fast, due to trying to maintain an artificially high exchange rate even in the face of soaring inflation – click to enlarge.
In Venezuela’s and Argentina’s case, the markets are rightly worried that the situation will probably deteriorate further. The intransigence of their governments with regard to pursuing economic policies that demonstrably don’t work and the resultant growing political risks conspire to create a highly unstable backdrop. As in all such cases, one must expect knock-on effects to emerge elsewhere.
Turkey has been hailed as a shining example of how an emerging economy should grow, but as is so often the case, it has in the meantime become evident that what it has mainly done was to engage in a massive credit-financed boom, displaying all the associated bubble activities, malinvestment of capital and overconsumption. This unsustainable boom was exacerbated by the fact that the Erdogan government pressured the central bank to keep rates extremely low. Even while prices were obviously misbehaving, with the rate of change of CPI oscillating between about 6.2% and nearly 11% and the stock market rising in parabolic fashion, the central bank kept its repo rate in the low single digits (this has only very recently changed).
With his country in the middle of a serious economic crisis, Erdogan has come under fire politically because his government has turned out to be a den of corruption to boot. So what does he do? He is taking a leaf from what the Western nations have demonstrated to be de rigeur these days, since don’t you know, we’re all surrounded by evil terrorists hiding in caves in the Hindu Kush somewhere. In short, he is moving toward increasingly authoritarian rule. Just take a look at this recent press report:
“Battling a corruption scandal, Turkish Prime Minister Tayyip Erdogan is seeking broader powers for his intelligence agency, including more scope for eavesdropping and legal immunity for its top agent, according to a draft law seen by Reuters.
The proposals submitted by Erdogan’s AK Party late on Wednesday are the latest in what his opponents see as an authoritarian backlash against the graft inquiry, after parliament passed laws tightening government control over the Internet and the courts this month.
The bill gives the National Intelligence Organisation (MIT) the authority to conduct operations abroad and tap pay phones and international calls. It also introduces jail terms of up to 12 years for the publication of leaked classified documents. It stipulates that only a top appeals court could try the head of the agency with the prime minister’s permission, and would require private companies as well as state institutions to hand over consumer data and technical equipment when requested.
“This bill will bring the MIT in line with the necessities of the era, grant it the capabilities of other intelligence agencies, and increase its methods and capacity for individual and technical intelligence,” the draft document said.
The ‘necessities of the era‘ – we couldn’t have put it in a more Orwellian fashion. And guess what? The vaunted ‘defenders of freedom’ in the West probably aren’t going to object for even a millisecond.
Turkey’s economy is a shambles right now, and Erdogan wants to cling to power by any means possible – that is what the ‘necessities of the era’ are really all about. For a long time it was held that the world as a whole was moving toward more, rather than less freedom. We regret to inform you that this trend has reversed more than a decade ago, on the day the WTC towers crumbled.
Meanwhile, what is now also crumbling is Turkey’s economy. However, we would argue that Turkey’s economic situation isn’t ‘unfixable’ if the proper policies are implemented quickly. After all, there has been a very successful period of economic liberalization under Erdogan’s government as well, which has left the economy more flexible and thus better able to deal with adverse developments. A wrenching adjustment is nevertheless unavoidable at this point.
Turkey has a large current account deficit. The fact that foreign investment inflows have now dried up is putting enormous strain on the economy. Consumer confidence has plunged, as has the currency – click to enlarge.
As one analyst sagely remarked:
“From 2009 to 2013, Turkey was considered by many to be a rising star among the emerging markets, but currently it may be the triggering force for worsening the emerging-market outlook globally in 2014.”
South Africa’s case is in many ways comparable to Turkey’s – the country also sports a large current account and trade deficit for example. However, while South Africa’s CPI ‘inflation’ rate has always been high by developed country standards, it has on average been much lower and less volatile than Turkey’s, fluctuating between 5% and 6.4% in recent years. Contrary to Turkey’s central bank, South Africa’s central bank is fiercely independent and focused solely on keeping CPI in check. In fact, it may well be one of the world’s most conservative central banks. It also refuses to intervene in the currency market and allows the Rand to go to wherever market forces push it. This non-intervention policy was actually quite difficult to defend while the Rand was among the world’s strongest currencies during the emerging markets boom of the 2000d’s. A plethora of special interests in South Africa were pleading with the central bank to do something to weaken the Rand, but it remained steadfast.
While the current account deficit means that more currency weakness is probably in store, South Africa does have a vibrant export sector. During the apartheid years, it had a perennial trade surplus, partly a result of being forced to conserve foreign exchange reserves in the face of economic sanctions. Similar to Turkey, South Africa imports all the oil it uses, which is a key vulnerability of both countries. However, the weakening of the Rand already has an effect: the trade balance has recently turned positive for the first time since 2010.
South Africa’s current account is still deeply in the red – click to enlarge.
However, a trade surplus has begun to emerge on the back of the weaker Rand – click to enlarge.
Investors in emerging markets like to use the Rand as a hedge for EM currency exposure, due to its relatively good liquidity and the fact that the central bank isn’t going to intervene directly. At times this fact probably exacerbates the moves in the Rand.
The political situation in South Africa is almost always somewhat dubious, and the Zuma presidency is no exception to that rule. There is a lot of corruption and quite a few economic policy decisions appear to us to be misguided. One must keep in mind in this context that the ANC government is continually under pressure to deliver an improvement in living standards to the formerly oppressed parts of the population, which often leads to the adoption of populist positions that are not economically sensible.
However, there exist also many misconceptions about SA and the ANC’s political legacy in the West. In spite of being formally allied with the communists (SACP) and the trade union umbrella body COSATU, the ANC has for instance privatized many of the companies that used to be state-owned under the national-socialist regime of the National Party (NP) that ruled the country during the apartheid years (a funny aside to this: the NP has dissolved itself and has been amalgamated with the ANC a few years ago). One slightly worrisome development is that the government deficit has grown sharply since 2010. While the government previously ran an almost balanced budget, the annual deficit amounted to more than 5% of GDP over the past four years. Nevertheless, due to the tight fiscal policy implemented previously, the public debt-GDP ratio is still below 40% – a number most developed countries can only dream of.
Sovereign Credit Risk
As can be seen above, the markets consider Turkey the second-smallest sovereign credit risk among the four nations at the moment. Its debt-to-GDP ratio is very similar to South Africa’s, at just 36%. The budget deficit has fluctuated between 2.8% and 5.5% of GDP over the past four years. Both data points are however what we would term ‘remnants of the bubble’, as the government’s tax revenues soared along with the economic boom. With the boom faltering, a sharp deterioration in these data points should be expected.
South Africa is actually in a slightly better position in this regard, as it has not experienced comparable boom conditions. Consequently the fact that the CDS spread on its sovereign debt is actually slightly below that of Turkey makes sense.
Argentina is currently considered the worst sovereign credit risk in the world – not least due to the fact that its foreign exchange reserves have declined dramatically and the trend is ongoing.
This throws more and more doubt on the country’s ability to service its foreign debt, which in the light of the 2001 default and its aftermath has made the markets wary. 5 year CDS spreads at 2,206 basis points reflect a great deal of risk (this represents an annual default probability of roughly 17% at an assumed 40% recovery rate).
Venezuela is lately catching up – its 5 year sovereign CDS spreads have soared to almost 1,700 basis points from less than 1,200 at the end of last year. This is testament to the fact that the economy has begun to implode under the Maduro government. While Maduro himself is just as bad as Chavez was in terms of economic policy, it should be pointed out that Chavez’ policies are what laid the foundations for current events. It has taken a while for this South America-style goulash-socialism to fail, as it allowed a remnant of the market economy to operate most of the time. However, the impositions on the private sector have simply become too onerous and galloping inflation has delivered the coup de grace, as economic calculation has become extremely distorted, if not nigh impossible.
The crisis in emerging market economies vulnerable to capital flight is unlikely to be over. Note that we have picked merely four cases, but there are several other developing countries that are currently in various states of political and economic crisis as well (e.g. India, Thailand, Brazil, to name a few). We have looked the two worst cases here, one of medium severity (Turkey) and one of the better cases (South Africa) in order to present as broad an overview as possible. The fate of Argentina and Venezuela is up in the air – it will require massive political change to alter their prospects.
However, other emerging market economies are bound to eventually bounce back and exhibit strong economic growth again. The imbalances can all be overcome, but the adjustments required are liable to play out in the form of economic and financial market crises of varying severity.
One must not forget in this context that Japan continues to pursue a mercantilist currency policy, which redounds on its competitors in Asia, which in turn affects their main suppliers. We continue to believe that Japan’s decision to weaken the yen has been a major contributor to recent currency turmoil elsewhere (of course, this does not mean that many of the countries concerned have not been wanting in terms of their own policies).
Moreover, China is hanging over the proceedings like the proverbial Sword of Damocles. HSBC has just reported its latest flash estimate on China’s manufacturing PMI (pdf), which was quite weak at 48.3, a seven month low indicating a worsening contraction. In view of the enormous credit bubble which China has embarked on since 2008 (about $15 trillion in additional debt have been created since then), the danger of a larger setback being set in motion by a sharp slowdown or even recession in China cannot be dismissed.
Charts by: Tradingeconomics, Reuters, Bloomberg
While Europe, and the bulk of the Developed World is struggling to dig out of its unprecedented credit crunch (in which central banks are the only source of credit money which instead of entering the economy is stuck in the capital markets via the reserve pathway) and resulting deflation, the rest of the Emerging Market world is doing just fine. If by fine one means inflation at what Goldman calls, bordering on “extreme levels.” This is shown in the chart below which breaks down the Y/Y change in broad prices across the main DM and EM countries, and which shows that when talking about inflation there are two worlds: the Emerging, where inflation is scorching, and Developing, where inflation is in a state of deep freeze.
What is notable here is that despite hopes for a convergence between the inflationary trends in the Developed (downside extremes) and Emerging (upside extremes) world for the past year, what has happened instead is an acceleration of the process especially in recent weeks as EMs have been forced to devalue their currencies at an ever faster pace in order to offset the impact of the taper, leading to surging inflation as Turkey, Argentina, and Venezuela among many others, have found out the hard way in just the past month.
And as inflation in EM nations continues to roil ever higher not only does the implicit exporting of deflation to the DM accelerate, but it means that their societies approach ever closert to the tipping point when the citizens decide they have had just about enough with their government and/or their currency and decide to change one and/or the other. Hopefully, in a peaceful matter.
Sri Mulyani Indrawati considers the reforms that emerging economies must undertake to succeed in the post-QE era. – Project Syndicate
The fact that the advanced economies are bouncing back is good news for everyone. But, for the emerging and developing economies that dominated global growth over the last five years, it raises an important question: Now, with high-income countries joining them, is business as usual good enough to compete?The simple answer is no. Just as an athlete might use steroids to get quick results, while avoiding the tough workouts that are needed to develop endurance and ensure long-term health, some emerging economies have relied on short-term capital inflows (so-called “hot money”) to support growth, while delaying or even avoiding difficult but necessary economic and financial reforms. With the US Federal Reserve set to tighten the exceptionally generous monetary conditions that have driven this “easy growth,” such emerging economies will have to change their approach, despite much tighter room for maneuver, or risk losing the ground that they have gained in recent years.
As the Fed’s monetary-policy tightening becomes a reality, the World Bank predicts that capital flows to developing countries will fall from 4.6% of their GDP in 2013 to around 4% in 2016. But, if long-term US interest rates rise too fast, or policy shifts are not communicated well enough, or markets become volatile, capital flows could quickly plummet – possibly by more than 50% for a few months.
This scenario has the potential to disrupt growth in those emerging economies that have failed to take advantage of the recent capital inflows by pursuing reforms. The likely rise in interest rates will put considerable pressure on countries with large current-account deficits and high levels of foreign debt – a result of five years of credit expansion.
Indeed, last summer, when speculation that the Fed would soon begin to taper its purchases of long-term assets (so-called quantitative easing), financial-market pressures were strongest in markets suspected of having weak fundamentals. Turkey, Brazil, Indonesia, India, and South Africa – dubbed the “Fragile Five” – were hit particularly hard.
Similarly, some emerging-market currencies have come under renewed pressure in recent days, triggered in part by the devaluation of the Argentine peso and signs of a slowdown in Chinese growth, as well as doubts about these economies’ real strengths amid generally skittish market sentiment. Like the turbulence last summer, the current bout of market pressure is mainly affecting economies characterized by either domestic political tensions or economic imbalances.
But, for most developing countries, the story has not been so bleak. Financial markets in many developing countries have not come under significant pressure – either in the summer or now. Indeed, more than three-fifths of developing countries – many of which are strong economic performers that benefited from pre-crisis reforms (and thus attracted more stable capital inflows like foreign-direct investment) – actually appreciated last spring and summer.
Furthermore, returning to the athletic metaphor, some have continued to exercise their muscles and improve their stamina – even under pressure. Mexico, for example, opened its energy sector to foreign partnerships last year – a politically difficult reform that is likely to bring significant long-term benefits. Indeed, it arguably helped Mexico avoid joining the Fragile Five.
Stronger growth in high-income economies will also create opportunities for developing countries – for example, through increased import demand and new sources of investment. While these opportunities will be more difficult to capture than the easy capital inflows of the quantitative-easing era, the payoffs will be far more durable. But, in order to take advantage of them, countries, like athletes, must put in the work needed to compete successfully – through sound domestic policies that foster a business-friendly pro-competition environment, an attractive foreign-trade regime, and a healthy financial sector.
Part of the challenge in many countries will be to rebuild macroeconomic buffers that have been depleted during years of fiscal and monetary stimulus. Reducing fiscal deficits and bringing monetary policy to a more neutral plane will be particularly difficult in countries like the Fragile Five, where growth has been lagging.
As is true of an exhausted athlete who needs to rebuild strength, it is never easy for a political leader to take tough reform steps under pressure. But, for emerging economies, doing so is critical to restoring growth and enhancing citizens’ wellbeing. Surviving the crisis is one thing; emerging as a winner is something else entirely.
Dani Rodrik reviews the fundamental lessons about emerging economies that economists have refused to learn. – Project Syndicate
But now the emerging-market blues are back. The beating that these countries’ currencies have taken as the US Federal Reserve begins to tighten monetary policy is just the start; everywhere one looks, it seems, there are deep-seated problems.
Argentina and Venezuela have run out of heterodox policy tricks. Brazil and India need new growth models. Turkey and Thailand are mired in political crises that reflect long-simmering domestic conflicts. In Africa, concern is mounting about the lack of structural change and industrialization. And the main question concerning China is whether its economic slowdown will take the form of a soft or hard landing.
This is not the first time that developing countries have been hit hard by abrupt mood swings in global financial markets. The surprise is that we are surprised. Economists, in particular, should have learned a few fundamental lessons long ago.
First, emerging-market hype is just that. Economic miracles rarely occur, and for good reason. Governments that can intervene massively to restructure and diversify the economy, while preventing the state from becoming a mechanism of corruption and rent-seeking, are the exception. China and (in their heyday) South Korea, Taiwan, Japan, and a few others had such governments; but the rapid industrialization that they engineered has eluded most of Latin America, the Middle East, Africa, and South Asia.
Instead, emerging markets’ growth over the last two decades was based on a fortuitous (and temporary) set of external circumstances: high commodity prices, low interest rates, and seemingly endless buckets of foreign finance. Improved macroeconomic policy and overall governance helped, too, but these are growth enablers, not growth triggers.
Second, financial globalization has been greatly oversold. Openness to capital flows was supposed to boost domestic investment and reduce macroeconomic volatility. Instead, it has accomplished pretty much the opposite.
We have long known that portfolio and short-term inflows fuel consumption booms and real-estate bubbles, with disastrous consequences when market sentiment inevitably sours and finance dries up. Governments that enjoyed the rollercoaster ride on the way up should not have been surprised by the plunge that inevitably follows.
Third, floating exchange rates are flawed shock absorbers. In theory, market-determined currency values are supposed to isolate the domestic economy from the vagaries of international finance, rising when money floods in and falling when the flows are reversed. In reality, few economies can bear the requisite currency alignments without pain.
Sharp currency revaluations wreak havoc on a country’s international competitiveness. And rapid depreciations are a central bank’s nightmare, given the inflationary consequences. Floating exchange rates may moderate the adjustment difficulties, but they do not eliminate them.
Fourth, faith in global economic-policy coordination is misplaced. America’s fiscal and monetary policies, for example, will always be driven by domestic considerations first (if not second and third as well). And European countries can barely look after their own common interests, let alone the world’s. It is naïve for emerging-market governments to expect major financial centers to adjust their policies in response to economic conditions elsewhere.
For the most part, that is not a bad thing. The Fed’s huge monthly purchases of long-term assets – so-called quantitative easing – have benefited the world as a whole by propping up demand and economic activity in the US. Without QE, which the Fed is now gradually tapering, world trade would have taken a much bigger hit. Similarly, the rest of the world will benefit when Europeans are able to get their policies right and boost their economies.
The rest is in the hands of officials in the developing world. They must resist the temptation to binge on foreign finance when it is cheap and plentiful. In the midst of a foreign-capital bonanza, stagnant levels of private investment in tradable goods are a particularly powerful danger signal that no amount of government mythmaking should be allowed to override. Officials face a simple choice: maintain strong prudential controls on capital flows, or be prepared to invest a large share of resources in self-insurance by accumulating large foreign reserves.
The deeper problem lies with the excessive financialization of the global economy that has occurred since the 1990’s. The policy dilemmas that have resulted – rising inequality, greater volatility, reduced room to manage the real economy – will continue to preoccupy policymakers in the decades ahead.
It is true, but unhelpful, to say that governments have only themselves to blame for having recklessly rushed into this wild ride. It is now time to think about how the world can create a saner balance between finance and the real economy.
One of the reasons the rich countries’ excessive money creation hasn’t ignited a generalized inflation is that today’s global economy is, well, global. When the Fed dumps trillions of dollars into the US banking system, that liquidity is free to flow wherever it wants. And in the past few years it has chosen to visit Brazil, China, Thailand, and the rest of the developing world.
This tidal wave of hot money bid up asset prices and led emerging market governments and businesses to borrow a lot more than they would have otherwise. Like the recipients of subprime mortgages in 2006, they were seduced by easy money and fooled into placing bets that could only work out if the credit kept flowing forever.
Then the Fed, spooked by nascent bubbles in equities and real estate, began to talk about scaling back its money printing*. The hot money started flowing back into the US and out of the developing world. And again just like subprime mortgages, the most leveraged and/or badly managed emerging markets have begun to implode, threatening to pull down everyone else. A sampling of recent headlines:
Prudent Bear’s Doug Noland as usual gets it exactly right in his most recent Credit Bubble Bulletin. Here are a few excerpts from a much longer article that should be read by everyone who wants to understand the causes and implications of the emerging-market implosion:
Virtually the entire emerging market “complex” has been enveloped in protracted destabilizing financial and economic Bubbles. In particular, for five years now unprecedented “developed” world central bank-induced liquidity has spurred unsound economic and financial booms. The massive investment and “hot money” flows are illustrated by the multi-trillion growth of EM central bank international reserve holdings. There have of course been disparate resulting impacts on EM financial and economic systems. But I believe in all cases this tsunami of liquidity and speculation has had deleterious consequences, certainly including fomenting systemic dependencies to foreign-sourced flows. In seemingly all cases, protracted Bubbles have inflated societal expectations.
For a while, central bank willingness to use reserves to support individual currencies bolsters market confidence in a country’s currency, bonds and financial system more generally. But at some point a central bank begins losing the battle to accelerating outflows. A tough decision is made to back away from market intervention to safeguard increasingly precious reserve holdings. Immediately, the marketplace must then contend with a faltering currency, surging yields, unstable financial markets and rapidly waning liquidity generally. Things unravel quickly.
The issue of EM sovereign and corporate borrowings in dollar (and euro and yen) denominated debt has speedily become a critical “macro” issue. More than five years of unprecedented global dollar liquidity excess spurred a historic boom in dollar-denominated borrowings. The marketplace assumed ongoing dollar devaluation/EM currency appreciation. There became essentially insatiable market demand for higher-yielding EM debt, replete with all the distortions in risk perceptions, market mispricing and associated maladjustment one should expect from years of unlimited cheap finance. As was the case with U.S. subprime, it’s always the riskiest borrowers that most intensively feast at the trough of easy “money.”
So, too many high-risk borrowers – from vulnerable economies and Credit systems – accumulated debt denominated in U.S. and other foreign currencies – for too long. Now, currencies are faltering, “hot money” is exiting, Credit conditions are tightening and economic conditions are rapidly deteriorating. It’s a problematic confluence that will find scores of borrowers challenged to service untenable debt loads, especially for borrowings denominated in appreciating non-domestic currencies. This tightening of finance then becomes a pressing economic issue, further pressuring EM currencies and financial systems – the brutal downside of a protracted globalized Credit and speculative cycle.
In many cases, this was all part of a colossal “global reflation trade.” Today, many EM economies confront the exact opposite: mounting disinflationary forces for things sold into global markets. Falling prices, especially throughout the commodities complex, have pressured domestic currencies. This became a major systemic risk after huge speculative flows arrived in anticipation of buoyant currencies, attractive securities markets, and enticing business opportunities. The commodities boom was to fuel general and sustained economic booms. EM was to finally play catchup to “developed.”
Now, Bubbles are faltering right and left – and fearful “money” is heading for the (closing?) exits. And, as the global pool of speculative finance reverses course, the scale of economic maladjustment and financial system impairment begins to come into clearer focus. It’s time for the marketplace to remove the beer goggles.
No less important is the historic – and ongoing – boom in manufacturing capacity in China and throughout Asia. This has created excess capacity and increasing pricing pressure for too many manufactured things, a situation only worsened by Japan’s aggressive currency devaluation. This dilemma, with parallels to the commodity economies, becomes especially problematic because of the enormous debt buildup over recent years. While this is a serious issue for the entire region, it has become a major pressing problem in China.
At the same time, data this week provided added confirmation (see “China Bubble Watch”) that China’s spectacular apartment Bubble continues to run out of control. When Chinese officials quickly backed away from Credit tightening measures this past summer, already overheated housing markets turned even hotter. Now officials confront a dangerous situation: Acute fragility in segments of its “shadow” financing of corporate and local government debt festers concurrently with ongoing “terminal phase” excess throughout housing finance. China’s financial and economic systems have grown dependent upon massive ongoing Credit expansion, while the quality of new Credit is suspect at best. It’s that fateful “terminal phase” exponential growth in systemic risk playing out in historic proportions. Global markets have begun to take notice.
There are critical market issues with no clear answers. For one, how much speculative “hot money” has and continues to flood into China to play their elevated yields in a currency that is (at the least) expected to remain pegged to the U.S. dollar? If there is a significant “hot money” issue, any reversal of speculative flows would surely speed up this unfolding Credit crisis. And, of course, any significant tightening of Chinese Credit would reverberate around the globe, especially for already vulnerable EM economies and financial systems.
No less important is the historic – and ongoing – boom in manufacturing capacity in China and throughout Asia. This has created excess capacity and increasing pricing pressure for too many manufactured things, a situation only worsened by Japan’s aggressive currency devaluation. This dilemma, with parallels to the commodity economies, becomes especially problematic because of the enormous debt buildup over recent years. While this is a serious issue for the entire region, it has become a major pressing problem in China.
The crucial point here is that this crisis is not a case of one or two little countries screwing up. It’s everywhere, from Latin America to Asia to Eastern Europe. Each country’s problems are unique, but virtually all can be traced back to the destabilizing effects of hot money created by rich countries attempting to export their debt problems to the rest of the world. ZIRP, QE and all the rest succeeded for a while in creating the illusion of recovery in the US, Europe and Japan, but now it’s blow-back time. The mess we’ve made in the subprime countries will, like rising defaults on liar loans and interest-only mortgages in 2007, start moving from periphery to core. As Noland notes:
Yet another crisis market issue became more pressing this week. The Japanese yen gained 2.0% versus the dollar. Yen gains were even more noteworthy against other currencies. The yen rose 4.2% against the Brazilian real, 3.9% versus the Chilean peso, 3.5% against the Mexican peso, 3.9% versus the South African rand, 3.8% against the South Korean won, 3.0% versus the Canadian dollar and 3.0% versus the Australian dollar.
I have surmised that the so-called “yen carry trade” (borrow/short in yen and use proceeds to lever in higher-yielding instruments) could be the largest speculative trade in history. Market trading dynamics this week certainly did not dissuade. When the yen rises, negative market dynamics rather quickly gather momentum. From my perspective, all the major speculative trades come under pressure when the yen strengthens; from EM, to the European “periphery,” to U.S. equities and corporate debt.
It’s worth noting that the beloved European “periphery” trade reversed course this week. The spread between German and both Spain and Italy 10-year sovereign yields widened 19 bps this week. Even the France to Germany spread widened 6 bps this week to an almost 9-month high (72bps). Stocks were slammed for 5.7% and 3.1% in Spain and Italy, wiping out most what had been strong January gains.
Even U.S. equities succumbed to global pressures. Notably, the cyclicals and financials were hit hard. Both have been Wall Street darlings on the bullish premise of a strengthening U.S. (and global) recovery and waning Credit and financial risk. Yet both groups this week seemed to recognize the reality that what is unfolding in China and EM actually matter – and they’re not pro-global growth. With recent extreme bullish sentiment, U.S. equities would appear particularly vulnerable to a global “risk off” market dynamic.
Developed world banks have lent hundreds of billions of dollars to emerging market businesses and governments. If these debts go bad, those already-impaired banks will be looking at massive, perhaps fatal losses. Meanwhile, trillions of dollars of derivatives have been written by banks and hedge funds on emerging market debt and currencies, with money center banks serving as counterparties on both sides of these contracts. They net out their long and short exposures to hide the true risk, but let just one major counterparty fail and the scam will be exposed, as it was in 2008 when AIG’s implosion nearly bankrupted Goldman Sachs and JP Morgan Chase.
Last but not least, individuals and pension funds in the developed world have invested hundreds of billions of dollars in emerging market stock and bond funds, which are now looking like huge year-ahead losers. The global balance sheet, in short, is about to get a lot more fragile.
So, just as pretty much everyone in the sound money community predicted, tapering will end sooner rather than later when a panicked Fed announces some kind of bigger and better shock-and-awe debt monetization plan. The European Central Bank, which actually shrank its balance sheet in 2013, will reverse course and start monetizing debt on a vast scale. As for Japan, who knows what they can get away with, since their government debt is, as a percentage of GDP, already twice that of the US.
The real question is not whether more debt monetization is coming, but whether it will come soon enough to preserve the asset price bubbles that are right this minute being punctured by the emerging market implosion. If not, it really is 2008 all over again.
The previous articles in this series:
* “Money printing” in this case refers to currency creation in all its forms, electronic and physical.
He accurately predicted the trends that have shaped the last decade. Ahead of the collapse of 2008 his Trends Journal newsletter issued a forecast that stock markets, which had just hit all time highs, would buckle in the first quarter of the year and that an unprecedented recession would blanket the global economy. He said the decline in financial markets would then be followed by disillusionment in America’s political and economic systems, leading to the rise of a third-party and widespread protests across America. And while officials the country over tried to assuage fears in the populace, he cautioned that the middle class would continue to be destroyed through taxation, regulation and fiscal incompetence.
His foresight was 20/20.
Now, renowned trend forecaster Gerald Celente warns that, despite establishment claims of recovery and growth, things are about to get a whole lot worse.
Celente isn’t suggesting that a massive collapse is going to happen in the future.
He says we’re already in it – and it’s taking hold right before our eyes across the entirety of the globe:
This selloff in the emerging markets, with their currencies going down and their interest rates going up, it’s going to be disastrous and there are going to be riots everywhere…
…So as the decline in their economies accelerates, you are going to see the civil unrest intensify.
If you want to know a business that will thrive in 2014, it may well beguillotines because these are ‘Off with their heads’ moments.
Meanwhile, they just passed laws in Spain to stop people from protesting. But all the laws in the world do not feed starving people. All the laws in the world do not put roofs over people’s heads.
That’s why you are going to see heads roll.
…you can already see chaos engulfing the world as the Fed’s global financial scheme is collapsing. This collapse is engulfing the entire world, from Russia, to South Africa, into China and emerging markets across the globe.
Should protesters in the U.S. threaten the status quo in any way they will be dealt with like the people who took to the streets in the Ukraine, Egypt, Iran, and Greece.
In fact, a Federal court recently upheld Congressional legislation passed in 2012 that allowed the herding of protestors into so-called “free speech” zones, and to charge those who assemble at “official functions” designated as areas of “national significance” with federal crimes punishable by one year in prison.
Under that verbiage, that means a peaceful protest outside a candidate’s concession speech would be a federal offense…
Carefully controlled protests involving individuals who have been bused in by their respective political party or union leaders are often televised by the mainstream media in an effort to give Americans a false sense of freedom.
When these protests turn to uprising and riots because millions of people can no longer keep a roof over their heads or food in their bellies, you can bet that those involved will be dealt with swiftly and behind the cloak of terrorism secrecy laws like the National Defense Authorization Act which essentially gives the government the right to detain anyone, for any reason, for an indefinite amount of time.
But the real question here is, why would the government need laws like this?
Why would they be war-gaming and simulating economic collapse scenarios and civil unrest?
Why are they continuing to borrow trillions of dollars from foreign creditors and injecting the domestic economy with tens of billions of dollars on a monthly basis?
The only plausible answer, given the current economic climate in America and sentiment on Main Street, is that the authorities at the highest levels of our government know that something very bad could happen.
And they confirmed this in two letters issued by two different Treasury Secretaries over the last several years. Most recently, the Treasury department noted that failure to satiate our nation’s never ending appetite for debt would have a “catastrophic effect” on our economy:
Credit markets could freeze, the value of the dollar could plummet, US interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.
Not only might the economic consequences of default be profound, but those consequences, including high interest rates, reduced investment, higher debt payments, and slow economic growth, could last for more than a generation…
The fall-out from our current economic climate is going to be unprecedented. For those who deny this is happening, understand that the above warning comes directly from our Treasury Department. They’re the money guys. And they are telling us what’s going to happen.
And be assured it won’t just be stock markets that drop precipitously.
What we’re talking about here is the collapse of the economy of the United States of America – the richest nation on Earth.
The consequences will be devastating on every level and those of us on Main Street will be taking the brunt of the impact.
Imagine a situation where jobs continue to be shed by the hundreds of thousands every month without abatement. A situation where the price of basic essentials like energy and food rise without restraint. A situation where medical care is so expensive that average Americans will go bankrupt trying to pay for government mandated coverage. A situation where whatever money you do have in savings becomes worthless because our currency loses credibility around the world.
This is what’s happening right now.
The scary version: There is no way to turn this around. It’s just going to get progressively worse.
This is the depression.
Some very relevant observations from Louis Gave of Evergreen GaveKal
Who Will The Emerging Markets Crisis Adjust Against?
In last summer’s emerging market sell-off, India was very much at the center of the storm: the rupee collapsed, bond yields soared and equity markets tanked. The Reserve Bank of India responded by raising rates while the government introduced harsh restrictions on gold imports. Promptly, the Indian current account deficit shrank. So much so that, in the current emerging market (EM) meltdown, India has been spared relative to most other current account deficit emerging markets, whether Turkey, Brazil, South Africa or Argentina. And on this note, the inability of the Turkish lira, South African rand, Brazilian real, etc. to hold on to gains after recent hawkish moves by their central banks is problematic. Markets won’t be calmed until there is clear evidence these countries’ current account deficits can improve. But how can these adjustments happen?
The problem is twofold. First, current accounts are a zero sum game, so future improvements in emerging market trade balances have to come at someone else’s expense. Second, we have had, over the past year, only modest growth in global trade; so if EM balances are to improve markedly, somebody’s will have to deteriorate.
When the 1994-95 “tequila crisis” struck, the US current account deficit widened to allow for Mexico to adjust. The same thing happened in 1997 with the Asian crisis, in 2001 when Argentina blew, and in 2003 when SARS crippled Asia. In 1998, oil prices took the brunt of the adjustment as Russia hit the skids. In 2009-10, it was China’s turn to step up to the plate, with a stimulus-spurred import binge that meaningfully reduced its current account surplus.
Which brings us to today and the question of who will adjust their growth lower (through a deterioration in their trade balances) to make some room for Argentina, Brazil, Turkey, South Africa, Indonesia…? There are really five candidates:
- China, again? That seems unlikely. Instead, China’s policymakers continue to do all they can to deleverage, despite the cost of a slowing economic expansion. Moreover, mercantilism still rides high in the corridors of power in Beijing and so the willingness to move to a current account deficit is simply not there.
- The US, again? As discussed in our recent book (see Too Different For Comfort), the Federal Reserve’s attitude since the global financial crisis has consistently been one of: “the US dollar is our currency and your problem.” The Fed has been happy to print and devalue the US dollar, leaving other countries to deal with the consequences. The days of the US acting as the backstop in the system are now behind us.
- Oil: In the past, collapsing oil prices have come to the rescue during emerging market crises. Of course, this accentuates problems for the EMs dependent on high energy prices for their growth, but is a boon for others (including India, China, Korea, Turkey). Unfortunately, for now, energy prices are not falling, with some more localized markets, like US natural gas, seeing a surge amid record cold snaps.
- Japan: Japan, which has been such a non-player for twenty years, is once again finding its feet. However, it is doing so by exporting its deflation through a central bank orchestrated currency devaluation. How this “beggar-thy-neighbor policy” will help the struggling emerging markets is hard to see, except perhaps through a) capital flows from rich Japanese savers into by now higher yielding EM debt, or b) import substitution on the part of threatened emerging markets where the end consumers will perhaps replace high priced US dollar/euro denominated imports of manufactured goods for cheaper yen denominated ones?
- Euroland: The currency zone’s slight trade surplus is largely due to Germany. However, Germany’s exports to Turkey, Russia, Brazil, etc., will likely suffer as domestic demand implodes in these countries. In this sense—the euroland will be the likeliest candidate on the other side of the EM current account adjustment. Unfortunately, odds are this will take place through falling European exports rather than rising European imports and/or rising EM exports to the eurozone. This is not a good harbinger for global growth.
In short, either oil collapses very soon, or the US dollar shoots up (with Janet Yellen about to take the helm, is that likely?) or we could soon be facing a contraction in global trade. And unfortunately, contractions in global trade are usually accompanied by global recessions. With this in mind, and as we argued in Eight Questions For 2014, maintaining positions in long-dated OECD government bonds as hedges against the unfolding of a global deflationary spiral (triggered by the weak yen, a slowing China, busting emerging markets and an uninspiring Europe…) makes ample sense.
The IMF’s woeful forecasting record, chronicled extensively before, has just taken yet another hit, following the latest flip flop on emerging markets. Try to spot the common theme of these assessments by the IMF.
IMF Chief economist Olivier Blanchard, April 11, 2011 (source):
“In emerging market economies, by contrast, the crisis left no lasting wounds. Their initial fiscal and financial positions were typically stronger, and the adverse effects of the crisis were more muted. High underlying growth and low interest rates are making fiscal adjustment much easier. Exports have recovered, and whatever shortfall in external demand they experienced has typically been made up through increases in domestic demand. Capital outflows have turned into capital inflows, due to both better growth prospects and higher interest rates than in the advanced economies. The challenge for most emerging market economies is thus quite different from that of the advanced economies—namely, how to avoid overheating in the face of closing output gaps and higher capital flows.”
IMF Chief economist Olivier Blanchard, July 9, 2013 (source):
“If you look country by country it seems to be specific . . . so in China it looks like unproductive investment, in Brazil it looks like low investment and in India it looks like policy and administrative uncertainty. But you wonder whether there is not something behind. I think behind this is a slowdown in underlying growth – not the cyclical component but just the average rate. It’s clear that these countries are not going to grow as fast as they did before the crisis.”
IMF Chief economist Olivier Blanchard, January 23, 2014 (source)
“Finally, we forecast that both emerging market and developing economies will sustain strong growth“
A few days later, EMs around the globe crashed, and central banks virtually everywhere had to step in to bail out their crashing currencies, and hit the tape with even more impressive verbal intervention every several hours.
Finally, today we get IMF economist Alejandro Werner, January 30, 2014 (source)
“Conditions in global financial markets will stay tighter than they were before the U.S. central bank’s “taper talk” in the first half of 2013, translating into higher international borrowing costs,particularly with the recent volatility in emerging markets…. sustained turbulence in emerging markets could tighten global financial conditions further…. Rebuilding fiscal buffers, and using monetary policy and flexible exchange rates to absorb shocks where possible, remains the order of the day.”
In other words, going from a forecast of “high underlying growth”, to “not going to grow as fast as they did”, to “sustain strong growth”, to violent EM crash, to “turbulence”, “volatility”, and urging EMs to “using monetary policy to absorb shocks”, what is clear is that nobody knows what is going on, nobody has any handle on the future of Emerging Markets, but let’s all just pretend that the MIT central-planners in control, are in control, and all shall be well.
Global stocks were hammered on Friday for a second straight day on news of a slowdown in China and turbulence in emerging markets. The Dow Jones Industrials suffered its worse drubbing in more than two years, tumbling 318 points on Friday to end a 490 point two-day rout. Emerging markets currencies were whipsawed by capital flight as foreign investors fled to the safety of U.S. Treasuries. Turkey’s lira and the Argentine peso were particularly hard hit setting record lows in the 48 hour period. The scaling back of the Fed’s $85 billion per month asset purchase program, called QE, has altered the dynamic that made emerging markets the “engines for global growth”. The policy reversal has triggered a selloff in risk assets and sent EM currencies plunging. Here’s a summary from Bloomberg:
“The worst selloff in emerging-market currencies in five years is beginning to reveal the extent of the fallout from the Federal Reserve’s tapering of monetary stimulus, compounded by political and financial instability.
Investors are losing confidence in some of the biggest developing nations, extending the currency-market rout triggered last year when the Fed first signaled it would scale back stimulus. While Brazil, Russia, India, China and South Africa were the engines of global growth following the financial crisis in 2008, emerging markets now pose a threat to world financial stability.” (“Contagion Spreads in Emerging Markets as Crises Grow,” Bloomberg)
Paradoxically, Bloomberg editors blame the victims of the Fed’s failed policy for the current ructions in the markets. In an article titled, “What’s Behind the Emerging-Market Meltdown” the editors say,”emerging-market governments … should recognize that this week’s financial-market turmoil was, to varying degrees, their own fault.” … “the best way for emerging-market governments to restore confidence would be to improve their policies.”
Logically, one would assume that the editors would throw their support behind capital controls or other means of stemming the destructive flow of speculative capital into domestic markets. But that’s not the case. What the editors really want, is policies that trim deficits, slash public spending, and allow foreign investors to continue to wreak havoc on vulnerable economies that follow their free market diktats. The article is a defense of the status quo, of maintaining the same ruinous policies so that profit-taking can continue apace.
The Fed was warned early on that its uber-accommodative monetary policy was spilling over into emerging markets and creating conditions for another financial crisis. Take a look at this excerpt from an article in Bloomberg back in 2010 where Nobel prize winning economist, Joseph Stiglitz, explicitly warns the Fed of the dangers of QE.
“The U.S. Federal Reserve’s plan to boost purchases of bonds poses “considerable” risks by increasing capital inflows to emerging markets, Nobel Prize- winning economist Joseph Stiglitz said in Santiago today.
“All this liquidity that they’re creating is not going back to grow the American economy and is going to Asia and other emerging markets where it’s not wanted,” Stiglitz said…..Increased capital inflows could cause emerging market currencies to appreciate and could create asset bubbles, he said.” (“Stiglitz Says Fed Stimulus Poses `Considerable’ Risks for Emerging Markets,” Bloomberg, Dec 2010)
Events have unfolded exactly as Stiglitz predicted they would, which means the Fed is 100% responsible the carnage in the stock and currencies markets.
The policy has pumped nearly “$7 trillion of foreign funds” into EMs since QE was first launched in 2009. According to the Telegraph’s Ambrose Evans-Pritchard, “much of it “hot money” going into bonds, equities and liquid instruments that can be sold quickly….Officials are concerned that this footloose capital could leave fast in a crisis, setting off a cascade effect,” Pritchard adds ominously.
Whether last week’s bloodbath was just a prelude to a bigger crash is impossible to say, but it is worth noting that the Fed has only reduced its purchases by a mere $10 billion per month while still providing $75 billion every 30 days. That suggests that markets will probably face greater turmoil in the months ahead. Check out this clip from USA Today:
“Emerging markets need the hot money but capital is exiting now,” says (Blackrock’s Russ) Koesterich. “What you have is people saying, ‘I don’t want to own emerging markets.’…
The bigger fear is if the current crisis in currency markets morphs into a full-blown economic crisis and leads to financial contagion, says Matthias Kuhlmey, managing director of HighTower’s Global Investment Solutions.
“The currency story is fascinating and can be a slippery slope – be cautious,” says Kuhlmey, adding that the Asian crisis in the summer of 1997 that started with a sharp drop in the value of Thailand’s baht, turned into a broader economic crisis that engulfed Indonesian, South Korea and a handful of other countries. It also rocked financial markets.” (“Why emerging markets worry Wall Street,” USA Today)
So, is this the Big One, the beginning of the next financial crisis?
It’s too early to say, but investors and analysts are worried. Fed tightening (via “taper”) will be felt in markets around the world. The trouble in emerging markets will intensify deflationary pressures in the Eurozone and put a damper on China’s growth. Slower global growth, in turn, will create balance sheets problems for undercapitalized and over-leveraged banks and other financial institutions which will increase the probability of another Lehman Brothers-type default.
According to Reuters, a normalizing of interest rates in the US, (which most analysts expect) “could cut financial inflows to developing countries by as much as 80 percent for several months. In such a case, nearly a quarter of developing countries could experience sudden stops in their access to global capital, throwing some economies into a balance of payments or financial crisis, the Bank said.” (“Rout in emerging markets may only be in Phase One,” Reuters)
Clearly, the potential for another financial meltdown is quite real.
For more than four years, the Fed has buoyed stock prices and increased corporate margins through massive injections of free cash into the financial markets. Now the Central Bank wants to change the policy and ease its foot off the gas pedal. That’s causing investors to rethink their positions and take more money off the table. What started as a selloff in emerging markets could snowball into a broader panic that could wipe out the gains of the last four years.
The Federal Reserve is entirely responsible for this new wave of financial instability.
Mike Whitney lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at email@example.com.