A
Scary Story for Emerging Markets
By John Mauldin
Oct 26,
2014
The
consequences of the coming bull market in the US dollar, which I’ve been
predicting for a number of years, go far beyond suppression of commodity prices
(which in general is a good thing for consumers – but could at some point
threaten the US shale-oil boom). The all-too-predictable effects of a rising
dollar on emerging markets that have been propped up by hot inflows and the
dollar carry trade will spread far beyond the emerging markets themselves. This
is another key aspect of the not-so-coincidental consequences that we will be
exploring in our series on what I feel is a sea
change in the global economic environment.
I’ve
been wrapped up constantly in conferences and symposia the last four days and
knew I would want to concentrate on the people and topics I would be exposed
to, so I asked my able associate Worth Wray to write this week’s letter on a
topic he is very passionate about: the potential train wreck in emerging
markets. I’ll have a few comments at the end, but let’s jump right into Worth’s
essay.
A Scary Story for Emerging Markets
By
Worth Wray
“The
experience of the [1990s] attests that international investors have
considerable resources at their command in the search for high returns. While
they are willing to commit capital to any national market in large volume, they
are also capable of withdrawing that capital quickly.”
– Carmen & Vincent Reinhart
“Capital
flows can turn on a dime, and when they do, they can bring the entire financial
infrastructure [of a recipient country] crashing down.”
– Barry Eichengreen
“The
spreading financial crisis and devaluation in July 1997 confirmed that even
economies with high rates of growth and consistent and open economic policies
could be jolted by the sudden withdrawal of foreign investment. Capital inflows
could … be too much of a good thing.”
– Miles Kahler
In
the autumn of 2009, Kyle Bass told me a scary story that I did not understand
until the first “taper tantrum” in May 2013.
He
said that – in additon to a likely string of sovereign defaults in Europe and
an outright currency collapse in Japan – the
global debt drama would end with an epic US dollar rally, a dramatic reversal
in capital flows, and an absolute bloodbath for emerging markets.
Extending
that outlook, my friends Mark Hart and Raoul Pal warned that China – seen then
by many as the world’s rising power and the most resilient economy in the wake
of the global crisis – would face an outright economic collapse, an epic
currency crisis, or both.
All
that seemed almost counterintuitive five years ago when the United States
appeared to be the biggest basket case among the major economies and emerging
markets seemed far more resilient than their “submerging” advanced-economy
peers. But Kyle Bass, Mark Hart, and Raoul Pal are not your typical “macro
tourists” who pile into common-knowledge trades and react with the herd. They
are exceptionally talented macroeconomic thinkers with an eye for developing
trends and the second- and third-order consequences of major policy shifts. On
top of their wildly successful bets against the US subprime debacle and the
European sovereign debt crisis, it’s now clear that they saw an even bigger
macro trend that the whole world (and most of the macro community) missed until
very recently: policy divergence.
Their
shared macro vision looks not only likely, not only probable, but IMMINENT
today as the widening gap in economic activity among the United States, Europe,
and Japan is beginning to force a dangerous divergence in monetary policy.
In a
CNBC interview earlier this week from his Barefoot Economic Summit (“Fed
Tapers to Zero Next Week”), Kyle Bass explained that this divergence is set
to accelerate in the next couple of weeks, as the Fed will likely taper its QE3
purchases to zero. Two days later, Kyle notes, the odds are high that the Bank
of Japan will make a Halloween Day announcement that it is expanding its own
asset purchases. Such moves only increase the pressure on Mario Draghi and the
ECB to pursue “overt QE” of their own.
Such
a tectonic shift, if it continues, is capable of fueling a 1990s-style US
dollar rally with very scary results for emerging markets and dangerous
implications for our highly levered, highly integrated global financial system.
As
Raoul Pal points out in his latest issue of The
Global Macro Investor, “The
[US] dollar has now broken out of the massive inverse head-and-shoulders low
created over the last ten years, and is about to test the trendline of the
world’s biggest wedge pattern.”
One
“Flight to Safety” Away from an Earth-Shaking Rally?
(US Dollar Index, 1967 – 2014)
(US Dollar Index, 1967 – 2014)
For
readers who are unfamiliar with techical analysis, breaking out from a wedge
pattern often signals a complete reversal in the trend encompassed within the
wedge. As you can see in the chart above, the US Dollar Index has been stuck in
a falling wedge pattern for nearly 30 years, with all of its fluctuations
contained between a sharply falling upward resistance line and a much flatter
lower resistance line.
Any
break-out beyond the upward resistance shown above is an incredibly bullish
sign for the US dollar and an incredibly bearish sign for carry trades around
the world that have been funded in US dollars. It’s a clear sign that we may be on
the verge of the next wave of the global financial crisis, where financial
repression finally backfires and forces all the QE-induced easy money sloshing
around the world to come rushing back into safe havens.
Let
me explain…
As
John Mauldin described in his recent letter “Sea
Change,” the state of the global economy has radically evolved in the wake
of the Great Recession.
Against
the backdrop of extremely accommodative central bank policy in the United
States, the United Kingdom, and Japan and the ECB’s “whatever it takes” commitment
to keep short-term interest rates low across the Eurozone, global debt-to-GDP
has continued its upward explosion in the years since 2008… even as slowing
growth and persistent disinflation (both logical side-effects of rising debt)
detract from the ability of major economies to service those debts in the
future.
Global
Debt-to-GDP Is Exploding Once Again
(% of global GDP, excluding financials)
*Data based on OECD, IMF, and national accounts data.
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.
(% of global GDP, excluding financials)
*Data based on OECD, IMF, and national accounts data.
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.
As
John Mauldin and Jonathan Tepper explained in their last book, Code Red, monetary
policies have fueled overinvestment and capital misallocation in
developed-world financial assets…
Developed
World Financial Assets Still Growing
(Composition of financial assets, developed markets, US$ billion)
(Composition of financial assets, developed markets, US$ billion)
Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.
…
but the real explosion in debt and financial assets has played out across the
emerging markets, where the unwarranted flow of easy money has fueled a
borrowing bonanza on top of a massive USD-funded carry trade.
Emerging-Market
Financial Assets Have Nearly DOUBLED Since 2008
(Composition of financial assets, emerging markets, US$ billion)
Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.
(Composition of financial assets, emerging markets, US$ billion)
Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.
These
QE-induced capital flows have kept EM sovereign borrowing costs low…
…
and enabled years of elevated emerging-market sovereign debt issuance…
…
even as many those markets displayed profound signs of structural weakness.
Raghuram
Rajan at the Bank of India explains
that this emerging-market borrowing binge is a logical consequence of “Code
Red” monetary policies like ZIRP, QE, and aggressive forward guidance in the
United States and other developed markets:
When
monetary policy in large countries is extremely and unconventionally accommodative,
capital flows into recipient countries tend to increase local leverage; this is
not just due to the direct effect of cross-border banking flows but also the
indirect effect, as the appreciating exchange rate and rising asset prices,
especially of real estate, make it seem that borrowers have more equity than
they really have.
But
the problem goes beyond a logical response to easy money. With growth in global
trade demand running well below the pre-2008 average, emerging markets face a
dangerous dilemma: slow down along with their developed-world customers (which
brings on the nasty prospect of social unrest and political regime change) or
lever up in an attempt to make the tricky transition to domestically led growth
(which may allow incumbent governments to stay in power).
Trouble
is, as we are seeing in China today, it is exceptionally difficult, if not
impossible, in the current weak trade/volatile capital flows environment, to
smoothly transition from an export-led growth model to a domestic
consumption-driven growth model without a major slowdown along the way. And
attempting to make the transition via debt-fueled, state-directed,
investment-led growth is likely to result in massive debt bubbles, unmanageable
piles of nonperforming loans, and the prospect of a very hard economic landing.
Brevan
Howard’s Luigi Buttiglione, along with co-authors Philip Lane, Lucrezia
Reichlin, and Vincent Reinhart, explained this dynamic in the latest Geneva
Report on the World Economy:
Some
nations that avoided the direct effects of the financial meltdown have recently
built up excesses that raise the odds of a home-grown crisis…. A number of emerging economies reacted
to the global crisis and the consequent slowdown in exports by switching from
export-led growth to domestically led growth, engineered by a strong expansion
in domestic credit…. The result was the strong increase in the
ratio of total debt (ex financials) to GDP for emerging economies, by a
staggering 36% since 2008. Higher leverage, although helping to shield these
economies from the chilling wind blowing from advanced economies, is an
increasing concern in terms of the future risk profile given the ongoing steep
slowdown of nominal growth, which reduces the “debt capacity” of emerging
economies exactly when they would need to expand it.
John
and I have written about this topic several times in the last year (“Central
Banker Throwdown” and “Every
Central Bank for Itself”), and I believe that understanding the massive
flows of capital from developed to emerging markets and the potentially
disastrous dynamics behind an abrupt reversal in the emerging-market bubble
boom may be the key to comprehending how the final act of the global debt drama
will play out.
After
years of enjoying relatively easy capital inflows and high levels of debt
growth against a backdrop of deteriorating fundamentals, the “Fragile Eight”
(Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, and Turkey)
find themselves in the “addicted to capital” phase of the balance of payments
cycle (outlined in the chart on the next page from Bridgewater Associates),
with high vulnerability to a reversal in flows.
According
to the latest Geneva report, these economies (shown as EM1 in the graph below)
have fallen into dangerous current account deficits compared to less fragile
emerging markets (EM2)…
Source: Buttiglione, Lane, Reichlin, & Reinhart.
“Deleveraging, What Deleveraging?” 16th Geneva Report on the Global
Economy, September 29, 2014.
…
and continue to exhibit a dangerous net-negative international investment
position, making the Fragile Eight serious candidates for capital flight.
Source: Buttiglione, Lane, Reichlin, &
Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on
the Global Economy, September 29, 2014.
Broad-based,
debt-fueled overinvestment may appear to kick economic growth into overdrive
for a while; but eventually, disappointing returns and consequent selling lead
to investment losses, defaults, and banking panics. And in cases where foreign
capital seeking strong growth in already highly valued assets drives the investment
boom, the miracle often ends with capital flight and currency collapse.
Economists
call that dynamic – an inflow-induced boom followed by an outflow-induced
currency crisis – a “balance of payments cycle,” and it tends to occur in three
distinct phases.
Bridgewater Associates, January 2014
In
the first phase an economic boom attracts foreign capital, which generally
flows toward productive uses and reaps attractive returns from an appreciating
currency and rising asset prices. In turn, those profits fuel a
self-reinforcing cycle of foreign capital inflows, rising asset prices, and a
strengthening currency.
In
the second phase, the allure of continuing high returns morphs into a growth
story and attracts ever-stronger capital inflows – even as the boom begins to
fade and the strong currency starts to drag on competitiveness. Capital piles
into unproductive uses and fuels overinvestment, overconsumption, or both, so
that ever more inefficient economic growth depends increasingly on foreign
capital inflows.
Eventually, the system becomes so unstable that anything from
signs of weak earnings growth to an unanticipated rate hike somewhere else in
the world can trigger a shift in sentiment and precipitate capital flight.
In
the third and final phase, capital flight drives a self-reinforcing cycle of
falling asset prices, deteriorating fundamentals, and currency depreciation…
which in turn invites more even more capital flight. If this stage of the
balance of payments cycle is allowed to play out naturally, the currency can
fall well below the level required for the economy to regain competitiveness,
sparking runaway inflation and wrecking the economy as asset prices crash.
In
order to avoid that worst-case scenario, central bankers often choose to spend
their FX reserves or to substantially raise domestic interest rates to defend
their currency. Although it comes at great cost to domestic growth, this kind
of intervention often helps to stem the outflows… but it cannot correct the core
imbalances. The same destructive cycle of capital flight, falling asset prices,
falling growth, and currency depreciation can restart without warning and
trigger – even years after a close call – an outright currency collapse if the
central bank runs out of policy tools.
John
and I believe that this worst case is the looming risk for many emerging
markets today, particularly in the externally leveraged “Fragile Eight”
(Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, and Turkey)
and, in the event of a forceful unwind in the USD carry trade, maybe even
China.
Not only have those countries amassed a disproportionate share of total
inflows to emerging markets, but each also has its own insidious combination of
structural and political obstacles to long-term growth. Each of these countries
is not without options, but the longer they delay in being proactive, the
greater the risk.
The
question for 2014 is, what happens when the tide of easy dollars reverses and
reveals a more challenging funding environment?
With
John’s blessing, I hope to profile each of the fragile emerging markets
individually in the coming months and in our upcoming book (working title: Sea Change); but for now I
have to limit our discussion to a couple of charts from a recent letter titled
“Carry Trade Junkies,” by my good friend Josh Ayers at Paradarch Advisors,
along with a few specific observations on three of the most fragile economies.
According
to official data reported by the Bank for International Settlements and the IMF,
Turkey, South Africa, and Chile look like obvious candidates for capital flight
and are three of the leading currency-crisis candidates.
Not
only do these economies rank among the most externally leveraged in the world…
External Debt to FX Reserves
Sources: Paradarch Advisors, BIS, IMF
…
but their banking systems also rank among the most externally leveraged.
External Bank Debt to FX Reserves
Sources: Paradarch Advisors, BIS, IMF
In
addition to enduring high levels of leverage that remain uncovered by FX
reserves,
Turkey, South Africa, and Chile are also liable to serious USD shock
risk, based on their economic fundamentals (unlike Poland and Hungary, which
are less likely candidates for immediate currency collapse given their very low levels of
domestic inflation).
The
lesson here is clear. The catalysts are already in position to spark an initial
flight to safety if the USD moves just modestly higher.
Some
economies (like Turkey, South Africa, and Chile) are more fragile than others
(like Russia, Brazil, and India); but an initial wave of crises can push the
USD higher and easily lead to larger accidents.
The experience of the 1990s
shows how, against the backdrop of a relatively
strong US economy and policy divergence between major central banks, extreme
stress in the emerging markets can lead to elevated US dollar strength, which
in turn can trigger additional crises and push the world’s reserve currency to
even greater heights. For example, the Mexican “Tequila Crisis” of 1994 played
a role in pushing the USD higher and, along with Bank of Japan easing, helped
trigger the Asian Financial Crisis in 1997. The Asian crisis, in turn, set off
a sharp jump in USD strength and an equally sharp fall in oil demand, which,
along with an oversupply of oil, contributed to a crash in oil prices in 1998
and threw Russia into crisis.
As
the example of Russia shows – and the inverse relationship between the US
dollar and oil prices highlights – this is not just a matter of capital inflows
turning into outflows, but rather inflows giving way to outflows while the
value of commodity exports falls simultaneously.
So, this dynamic gets more and more dangerous for increasingly fragile
economies as the dollar reaches new heights and commodity markets are stressed.
US
Dollar Index vs. WTI Crude Oil
Turkey,
South Africa, and Chile may be the likely “first wave,” which policymakers
around the world may see as inconsequential… but it’s easy to see how that
first wave could grow into a tsunami.
When
asked about the concept of financial repression (a technical term for policies
that are intended to fuel a domestic wealth effect and force savers to take on
more and more risk over time to maintain a manageable level of income), former
Treasury Secretary (and recent Fed Chairman runner-up) Larry Summers recently
commented, “I think the instinct to financial repression is there. But it strikes me that the world is
pretty global and there are a lot of places to put money, and even if one
wanted to financially repress, I don’t think that [in] most of the
industrialized world is going to be that easy on a large scale.”
(Click
here & fast-forward to the 1:03:48 point to see his comments.)
It
never made the nightly news, the front page of the New York Times, or even the news page on
Bloomberg, but Summers’ comment is a tremendous revelation from the man who
almost succeeded Ben Bernanke as Fed Chairman earlier this year.
By
trying to shore up their rich-world economies with unconventional policies like
ultra-low nominal interest rates; outright balance-sheet expansion; and
aggressive, open-ended forward guidance, major central banks have dramatically
widened international real interest-rate differentials and forced savers to
seek out higher (and far riskier) returns for more than five years running.
But
that money did not just move further out on the risk spectrum from low-yielding
cash equivalents to higher-yielding assets like US stocks, high-yield bonds,
and MLPs. In the process of fighting naturally deflationary impulses and
forcing investors to take more risk, the Federal Reserve has also forced an
enormous amount of money to move out of the United States and into the emerging
world. The risks have been clear to policymakers all along, but emerging
markets are well outside of the Fed’s mandate. They are collateral damage, so
to speak.
In
his latest issue of Global
Macro Investor, Raoul Pal estimates that the resulting carry trade
has grown to roughly $3 trillion into major emerging economies (excluding
China) and nearly $2 trillion into China alone. My friend Mark Hart comes up
with similar numbers for “unexplained inflows” by backing the sum of foreign
direct investment and trade out from the total growth in FX reserves, and he
discusses the situation at length in a recent “Master Class” interview with
Raoul Pal on Real
Vision TV. These are staggering numbers, even compared to the massive
Japanese yen carry trade that had grown to roughly $1 trillion by 2007; and
they add up, quite simply, to the Mother of All Carry Trades… which can unwind
VERY QUICKLY in the event of a major US dollar rally. Shades of 2008.
That’s
the flip side to years of low rates, QE, and aggressive forward guidance. The
Fed buys time for the US economy to find its footing at the expense of rampant
misallocation across the rest of the world. Major developed economies can
adjust their policies to offset the effects, but the emerging markets find
themselves in a far more vulnerable position as easy money masks the urgent
need for reforms. And once the Fed reverses its policy to reflect relative
strength in the US economy, it’s a bloodbath for economies that cannot adjust
easily, which in turn pushes the US dollar even higher and starts to take a
serious toll on real economies… like China’s, where state-sanctioned data
dramatically understates the extent of the world’s most dangerous debt bubble.
In
the days leading up to All Hallows Eve, the prospect for a US dollar rally
should inspire more fear than any campfire ghost story or voodoo curse. This is
a realistic and increasingly probable outcome; and the last time the world saw
a series of emerging-market crises (first in Mexico in 1994 and then in
Southeast Asia in 1997) against the backdrop of a weak Japanese economy and a
relatively stronger US economy, it pushed the US dollar to such heights that it
triggered a 50% collapse in oil prices, pushed Russia’s economy over the edge
in 1998, and blew a hole in the side of a highly levered hedge fund, Long Term
Capital Management, that nearly brought down the global financial system.
The
next round of policy divergence could be far more destructive than that,
because this time the global financial system is far more levered; instability
is far more widespread; and the amount of money required to backstop an
accident will be greater than the Fed’s entire bloated balance sheet. These are
the logical consequences of post-2008 financial repression, and they’re the
reason why emerging-market central bankers like Raghuram Rajan are calling
loudly for better coordination of global monetary policy.
It
is indeed every central bank and country for itself, and that is a recipe for
volatility and financial losses. If you think this story has a happy ending,
you are not paying attention to history.
Geneva, Atlanta, and New York
I
write this at the end of a very packed four days of constant mental
stimulation. The Barefoot Summit at Kyle Bass’s ranch in East Texas was up to
its usual high standards. And due to the rain we have had all summer, East
Texas is about as pretty as I have ever seen it. And the weather was perfect.
It was a great setting in which to sit and talk all things macro. Sen. Tom
Coburn was in attendance (along with a few other political types), and I find
him to be a thoroughly delightful and thoughtful man. I am sad to see his
wisdom leave the Senate but understand the personal reasons. We need more men like
him in government.
And
while the weather in Boston was not initially welcoming, it has turned
absolutely beautiful today. Niall Ferguson and his team at Greenmantle have put
together a most thought-provoking conference. The gathering was held under strict
Chatham House rules, so while I can share my thoughts about it, I can’t
describe the actual conversations or the people involved without their
permission. As you might expect of a man with Niall’s resources and
connections, he was able to pull together fascinating panels and presentations
of the highest quality. We were treated to in-depth analysis of almost every
region of the world as well as to presentations of new ideas and technologies;
and the forum was small enough to allow for very active debate.
Tomorrow
I fly to Washington DC and then on to Geneva for a few days of meetings and
some time to gather my thoughts before returning to Atlanta for a day before I
finally head back to Dallas in time for Halloween.
I’m
going to go ahead and hit the send button without my usual final comments, as I
want to get to the gym and there is a full evening planned for tonight. You
have a great week.
You’re more convinced about a dollar
bull market than ever analyst,
John Mauldin
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