Developing Crisis in the Developing World, Part 2: When the Hot Money Leaves
One of the reasons that the developed world seems relatively stable while our debt, currency creation and unfunded liabilities go crazy is that we have a safety valve. When the Fed or ECB or Bank of Japan lowers interest rates to zero or buys up trillions of dollars of bonds with newly-created currency, a lot of that potentially-destabilizing liquidity flows elsewhere, mostly to emerging markets like Brazil, China and India - where it frequently causes booms and busts that, in relative terms, can dwarf those of the developed world. While hot money is flowing in, it spikes asset prices and food inflation, forcing developing countries to take unpopular steps like raising taxes and interest rates to avoid destabilizing bubbles. When it flows back out, it crashes local stock, bond and currency markets and turns boom into abject bust. That's happening now in what not so long ago were the most promising emerging countries. As CNN reports:
Despite worries about the Fed tapering, U.S. stocks have held up well. The same can't be said for emerging markets.
India's stock market is in tatters lately as its currency, the rupee, hit a record low. Brazil's Bovespa is one of the worst performing markets this year. The Hang Seng in Hong Kong and China's Shanghai Composite are in the red this year. Smaller emerging markets, such as Turkey and Indonesia, have taken it on the chin too.
So instead of crying about the recent drop in the S&P, be thankful you don't own the iShares MSCI Emerging Markets (EEM) exchange-traded fund ... assuming, of course, that you don't own that ETF. If you do, feel free to turn on the waterworks.
Brazil, meanwhile, was the poster child for hot money back in 2010, when its currency, domestic prices, and consumer debt all soared and its officials began complaining publicly about a "currency war". Now it's an object lesson in the damage hot money does when it departs. In response, Brazil has begun to tighten aggressively by using its foreign exchange reserves to buy up its currency, the real:
Brazil's central bank said Friday it will launch a $60 billion program to halt a slide in its currency, which has fallen in recent days to its lowest level since 2008.
The series of currency swaps and loans, worth $3 billion per week, will be carried out on a regular schedule for the remainder of the calendar year. The bank, which previously announced a smaller intervention, said in a statement that it reserves the right to perform additional operations if appropriate.
The move comes as talk of tighter U.S. monetary policy has seen some investors pull out of emerging markets in recent months. The Fed has bought some $3 trillion worth of assets since it launched quantitative easing in 2008. Much of that money has found its way into stocks in developing economies as investors ventured into more risky assets.
With investors now pulling out, currencies in countries like India and Indonesia have touched fresh lows in recent days. Brazil's currency, the real, had been trading at around 2.00 against the dollar as recently as April, but now stands at 2.44.
The sudden decline in the real's value raises the prospect of further inflation, which is already racing above an annual rate of 6% -- and perilously close to the government's 6.5% target ceiling. Adding to worries, the country's Bovespa index has been among the world's worst performers, losing more than 15% of its value since January.
This is a seriously sweet deal for the US. When we're liquefying the banking system to manage our excessive debts, those helpful emerging markets bear the destabilizing brunt of our exported inflation. When we decide to stop flooding the system with dollars, the emerging markets return the hot money to us to prop up our stocks and bonds. All the gain from easy money with little or none of the pain.
But like most too-good-to-be-true situations, this one may be about to end, according to Telegraph's Ambrose Evans-Pritchard:
India's rupee and Turkey's lira both crashed to record lows on Thursday following the US Federal Reserve releasing minutes which signalled a wind-down of quantitative easing as soon as next month.
Dilma Rousseff, Brazil's president, held an emergency meeting on Thursday with her top economic officials to halt the real's slide after it hit a five-year low against the dollar. The central bank chief, Alexandre Tombini, cancelled his trip to the Fed's Jackson Hole conclave in order "to monitor market activity" amid reports Brazil is preparing direct intervention to stem capital flight.
The country has so far relied on futures contracts to defend the real - disguising the erosion of Brazil's $374bn reserves - but this has failed to deter speculators. "They are moving currency intervention off balance sheet, but the net position is deteriorating all the time," said Danske Bank's Lars Christensen.
A string of countries have been burning foreign reserves to defend exchange rates, with holdings down 8pc in Ecuador, 6pc in Kazakhstan and Kuwait, and 5.5pc in Indonesia in July alone. Turkey's reserves have dropped 15pc this year.
"Emerging markets are in the eye of the storm," said Stephen Jen at SLJ Macro Partners. "Their currencies are in grave danger. These things always overshoot."
It was Fed tightening and a rising dollar that set off Latin America's crisis in the early 1980s and East Asia's crisis in the mid-1990s. Both episodes were contained, though not easily.
Fears of Fed tightening have pushed borrowing costs worldwide to levels that could threaten global recovery. Yields on 10-year bonds jumped 47 basis points to 12.29pc in Brazil on Thursday, 33 points to 9.72pc in Turkey, and 12 points to 8.4pc in South Africa.
Hans Redeker from Morgan Stanley said a "negative feedback loop" is taking hold as emerging markets are forced to impose austerity and sell reserves to shore up their currencies, the exact opposite of what happened over the past decade as they built up a vast war chest of US and European bonds.
The effect of the reserve build-up by China and others was to compress global bond yields, leading to property bubbles and equity booms in the West. The reversal of this process could be painful.
"China sold $20bn of US Treasuries in June and others are doing the same thing. We think this is driving up US yields, and German yields are rising even faster," said Mr Redeker. "This has major implications for the world. The US may be strong to enough to withstand higher rates, but we are not sure about Europe. Our worry is that a sell-off in reserves may push rates to levels that are unjustified for the global economy as a whole, if it has not happened already."
A quick end to tapering talk?
Once China, India and Brazil really start dumping their treasury bonds, is there anything the Fed can do to stop them? In the short run, probably yes. It could reverse course, expand its bond purchases enough to push prices up and yields down at the margin, and so start a new round of hot money flowing into emerging markets. Which would reignite asset bubbles all over the world and set the stage for a bigger crash a few years down the road.
And that's the optimistic scenario. If the bond selling gets out of hand, forcing up US interest rates, crashing the housing and stock markets and sending the dollar either way up or way down (it's hard to know which it would be in this kind of chaos) then we'll get to see how the other half copes.