First, bravo to the Bernanke Fed for staying the course and learning from its September mistake: Don’t mislead the markets with a sudden change of direction. It appears that the Fed will provide investors with enough “forward guidance” if they wish to alter the market’s perceptions. FOMC members had plenty of time to dissuade traders if the recent slew of tepid data was going to steer Bernanke and Company away from another cut in QE purchases. The FED erred on the side of consistency rather than swerving to avoid the skidding emerging markets. Again, a FED pause would have further roiled a very nervous global financial market.
Secondly, while economists projected a 38% probability of a New Zealand rate increase (h/t Carl), RBNZ Governor Wheeler bowed to the extremely strong KIWI and refrained from raising rates. Many analysts failed to appreciate that an ultra-strong currency acts as a rate increase over time. The Aussie/Kiwi cross at 35-year lows was enough to force the RBNZ to stay the course. Today’s Aussie dollar rally versus the KIWI is testimony to the correctness of the decision.
***To follow-up on today’s interview with Rick Santelli, the issue with the market’s recent reaction to the turmoil in the emerging markets has to be put into perspective. The airwaves have been filled with the SOPHISTRY of armchair pundits stating that the present situation is very similar to the Asian contagion of 1997 and 1998. I BELIEVE THIS TO BE FALLACY BY CORRELATION. All emerging markets are dependent on the flows of hot money, therefore they are all subject to the same reflexive response to the Fed’s ending of QE.
First: Unlike the 1990s, most emerging market currencies are not pegged to the DOLLAR but are allowed some type of float. Since Mexico suffered the TEQUILA CRISIS in December 1994, the Mexican peso has been allowed to float, in which the currency seeks a daily value determined by market forces. The Mexican government has gained the confidence of the markets and therefore has been able to fund more of its borrowings in PESOS rather than DOLLARS. The biggest problem for the EMERGING MARKET COUNTRIES is having to fund themselves in foreign currency so as to avoid the higher lending costs the market demands from borrowing in an unreliable domestic currency. When an EM country runs into economic problems–usually too much debt relative to economic growth–the cost of borrowing rises dramatically. If an EM country runs a current account deficit, or a massive trade deficit, the usual antidote is a devaluation of its currency so as to improve its trade competitiveness.
However, if the EM‘s debt is valued in a foreign currency, the depreciation of its domestic currency drives up the value of its loans causing the debt load to explode. A floating currency keeps the market abreast of any impending problems. The Mexico peso has avoided the recurring crises that plagued its economy in the 80s and 90s. The Asian contagion, Long Term Capital, dotcom implosion, subprime loans and all recent problems have failed to push Mexico into another TEQUILA/PESO crisis.
Next, I went back and researched the CURRENT ACCOUNT BALANCES of several emerging market countries from the previous crisis to the present so as to determine if there is structural funding issues or merely the “nattering nabobs of negativity.” I measured the current account balances in terms of GDP.
- RUSSIA: During the 1998 crisis, the Russian current account was -2% and the RUBLE was trading at a fixed rate of SIX to the dollar. The present current account is 1.96% and the ruble is currently at 35 to the dollar. Yes, Russian inflation certainly erodes some of the value, but the picture is certainly different.
- BRAZIL: The situation is deteriorating for Brazil, but the REAL has been adjusting over the last 30 months since the FLOATING REAL has dropped 65% in value to the U.S. dollar. Therefore, the current account and trade balance will begin to adjust. Over the same 30 months, the current account balance has gone from -2% of GDP to 3.59%. Problematic but not a crisis.
- TURKEY: The Turkish lira is a bigger problem as the current account deficit has gone from 2% in 2010 to 7.22%. In 2011, the current account deficit actually rose to almost 10% but the Turkish Lira was 30% stronger. It will take some time but the trade deficit and current account will improve as Turkish exports become cheaper and imports more expensive.
- SOUTH AFRICA: This country may be the biggest problem as its current account has plunged from a 1.5% GDP deficit in 2010 to a 6.8% shortfall. The RAND has dropped 55% in value but the increase in the current account deficit has been much more dramatic. South Africa will be a tougher problem and its interest rates are only half of Turkey’s.
- MEXICO: In 1995, the Mexican current account deficit was 5.8% to GDP and the peso was trading at about SIX to the U.S. dollar. Most of the Mexican borrowing was in DOLLARS. Today, the Mexican government funds mush of its finances in the domestic peso market and the current account deficit is 1.81% of a much greater GDP. Now the Mex Peso is trading at 13.5 to the U.S. dollar.