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.
Tags: Brazil, current account deficits, Fed, FOMC, Mexico, New Zealand, Peso, QE, rand, Real, ruble, Russia, South Africa, Turkey, Turkish lira, Wheeler
January 30, 2014 at 6:17 pm |
Yra,
Thanks for reminding me that history may rhyme, but does seldom repeat itself. Your analysis of each element of each market is a prudent exercise, while drawing parallels is the lazy (and often wrong) analysis.
Kevin
January 30, 2014 at 11:58 pm |
Hi Professor Ira, I’m afraid I’m going to have to take advantage of your office hours to clarify my understanding of your fascinating lecture. Sometime you call it a current account deficit (example Turkey going from 2% to 7.22% … not good), and sometime you refer to it just as a current account and place a minus sign in front of it (example Russia in 1998 the current account was -2%, and at the present it is 1.96% … good, since it went from a negative to a positive); so can I assume that in your lecture a current account deficit of 2% of GDP is the same as a current account of -2% of GDP? And if I’m reading the figures correctly (at least the current account as a percent of GDP) the order of performance of the five countries you listed is: Brazil (from -2% to + 3.59%); Russia (from -2% to +1.96%); Mexico (from -5.8 to -1.81%); Turkey (from -2% to -7.22%); and South Africa (from -1.5% to-6.8%). And interesting enough the ranking seems to correlate somewhat with the rate of currency devaluation (vs the dollar) that has occurred in each country respectively. So is the takeaway that the first three countries are headed in the right direction (and not subject to a “structural funding issue”) and the last two countries are headed in the wrong direction (and could have a “structural funding issue”)? And does it seem that deflating against the dollar might be the salvation of the last two countries? And finally I’m not looking for a better grade in saying this, but I really have been enjoying your classes.
January 31, 2014 at 1:36 am |
What is the danger of each threatened currency resorting to competitive devaluations, which 80 years ago got out of hand? How do Argentina and Venezuela compare today with over a decade ago? Could QE at some point lead to the dollar leading a bout of currency wars? If the U.S. economy slows down, wouldn’t the Yellin Fed reverse the tapering course and move to amplification (is that the proper antonym?)? We have avoided that until now, but isn’t the threat out there?
January 31, 2014 at 8:06 am |
I really appreciate these analysis Ira, thanks for the explanations.
January 31, 2014 at 8:11 am |
Yra, I think the bigger problem is that these EM problems are happening within a totally mispriced and destabilized world economic system, brought on by QE, ZIRP, supporting bad assets,etc, and a level of debt that is unsustainable. The EM countries are the canaries in the coal mine.
January 31, 2014 at 9:36 am |
Lou–sorry Brazil should be a minus[deficit]–all else you have correct
January 31, 2014 at 2:17 pm |
Thus, assuming I’m comprehending correctly, Brazil’s account deficit has deteriorated from -2% to -3.59% over the period while Mexico’s has improved from -5.8% to -1.81%.
January 31, 2014 at 2:38 pm |
absolutely–now the complete analysis will be to also measure the non-inflationary growth in the GDP—but Chicken–you see the dramatic improvement
January 31, 2014 at 5:11 pm |
I see your point Ira, the Mexican peso has depreciated from 6 to the today’s < 13.5 over the period. Looking the chart over, a 7 month pendent breakout of 13.461 suggests a potential run to 15~17
This formation appears to have recently failed though, and thus Mexican Peso has recently begun appreciating.
January 31, 2014 at 6:35 pm |
Yra, Could you explain why the pundits say that QE Taper is hitting the emerging markets? Rates have gone down this year, despite the Taper, so I don’t get it.
January 31, 2014 at 10:51 pm |
So whomever is offering CDS’s on EM debt is probably raking in the business about now, wouldn’t you think?
February 1, 2014 at 12:21 am |
Debt denomination – And, it should matter if the EM government debt is denominated in $US or the local currency, because if the local currency is under pressure but the debt principal and interest are due in $US, then it will make it more expensive for the government to service their debt, ie: converting tax receipts in the local currency into $US for servicing debt will bring extra cost.
February 1, 2014 at 10:25 am |
Shocked to Find Gambling,
I am no expert, and I’m sure there are several who will disagree, but I BELIEVE the reason is the QE currencies were searching for RETURNS. With Bonds high, real estate high, US, DM Equities overvalued, the QE found its way to EM. Now, there is less QE finding its way to EM, therefore specs are jumping ship.
Yra, Do I have that correct? I’m sure it’s more complex than that though.
February 1, 2014 at 10:51 am |
Nate,
That makes sense, EXCEPT that U.S. Treasury rates have gone down during the last phase of the EM problems, so Treasuries are now a less competitive investment. I’m missing something here.
February 1, 2014 at 11:38 am |
Risk?
February 1, 2014 at 11:40 am |
I’ll offer you 12%, but there is a 99% chance it will fail, or I’ll give you 2%, with a 1% chance it will fail… Hyperbole, but what I think is happening.
I should have said PERCEIVED RISK in my last statement.
February 1, 2014 at 3:02 pm |
Doff of the cap to anyone who profits from an excellent analysis of this world-over chess game, that when over, winner takes nothing.
February 2, 2014 at 4:56 pm |
Nate–dead bang on–remember a central theme of my thought process and this blog is the relative nature of global finance.Politics and economics are our focus and when money seeks stability rather then higher yields we pay close attention.
February 4, 2014 at 8:25 am |
Yra-There is plenty of USD debt held by EM corporations. I remember a few years back reading a piece on the Turks taking advantage of low US rates and a falling dollar and borrowing aggressively in USD. This happened all throughout EM’s. So as far as EM currencies go I am not interested in being long even for a rally here or there. However, I think EM economies will not collapse and growth will adjust as their currencies adjust much like you have pointed out. But, if EM central banks fight depreciation and raise rates too much my position would change quickly. They must take the short-term pains of panicked capital outflows and a falling currency to sustain growth in the intermediate to long-term. Aggressive rate rises are not the answer! The Rotten Heart of Europe is great at making this clear in the case of several countries during the ERM era.
February 4, 2014 at 11:42 am |
Dustin –very good post and I would advise reading a piece released today by the BIS Working paper 441—by Philip turner
February 5, 2014 at 7:23 am |
Yra- Thanks for the recommended reading! I very much enjoyed the paper. It was good to see data on just how large international bond markets have become relative to bank lending of late. Also appreciated the calculation of the US nominal term premium since 2000 which would seem to go a long ways in explaining long-term foreign corporate and foreign subsidiary borrowing in USD and leaving much of this exposure unhedged. Plenty of useful tidbits of info all throughout.