A global shock is building. The Minsky moment is not yet here and could be tomorrow or a year away but we can see its outline approaching. We are sometime in mid-2007 with the sub-prime bubble in serious jeopardy but no credit event as yet to turn it into crisis and panic.
This time around it is sub-prime lending in commodities and emerging markets. How can we know this? Let’s begin with Bloomberg and its roll up of strife-torn emerging market currencies:
* Saudi Arabia’s riyal: Armed with $672 billion in foreign reserves, Saudi Arabia, the world’s largest oil exporter, has enough capacity to hold the peg, according to Deutsche Bank AG. Nonetheless, speculators are betting on a break of the currency regime as crude oil tumbled to a seven-year low.
* Turkmenistan’s manat: This oil-exporting nation with close economic ties to Russia devalued its currency by 19 percent in January. Stockholm-based SEB AB forecasts a further weakening of as much as 20 percent in the next six months.
* Tajikistan’s somoni: The nation has close ties with Kazakhstan, which accounts for about 11 percent of trade, and SEB expects a depreciation of 10 to 20 percent.
* Armenia’s dram: The currency has lost 15 percent in the past 12 months, compared with a 46 percent drop in the ruble. A quarter of the country’s trade is with Russia.
* Kyrgyzstan’s som: The weaker tenge will put pressure the som because of this country’s ties to Kazakhstan, according to BMI Research.
* Egypt’s pound: The country has limited investors’ access to foreign currencies amid a shortage since the 2011 Arab Spring protests. Traders are betting the pound will weaken about 22 percent in a year, according to 12-month non-deliverable forwards.
* Turkey’s lira: It’s one of the world’s worst-performing currencies since China’s devaluation on Aug. 11. An escalation in political violence and the probability of early elections compound the issues.
* Nigeria’s naira: Policy makers in this oil-exporting nation are trying to hold the currency at a level most see as too high. Trading in forwards indicates the currency will fall more than 20 percent against the dollar over the next year.
* Ghana’s cedi: Also an oil exporter, though its main problems are mainly fiscal imbalances, rising inflation and increasing debt.
* Zambia’s kwacha: The country is heavily exposed to China as copper accounts for about 70 percent of exports.
* Malaysia’s ringgit: The currency slid to a 17-year low on Thursday and foreign-exchange reserves fell below the $100 billion mark for the first time since 2010.
Why are these currencies falling and expected to keep doing so? Three reasons: the Fed is tightening monetary policy and sucking liquidity from global markets; China is devaluing and continuing to do so will put pressure on its emerging market competitors; commodity prices (especially oil) are hammering these nation’s external accounts and hitting them hard with deflation making the capital flight driving up their interest rates uber-toxic.
Of these three, we are going to see the Fed pause soon enough. But commodity deflation and Chinese devaluation are caught in a feedback loop. From Deutsche via FTAlphaville:
One of the big problems with China’s FX move is that although they’ve ‘only’ seen a 3% currency fall (in the onshore Yuan) since their announcement last week, others have subsequently followed suit either deliberately or via market [and oil based] pressure. The following countries have seen their currency depreciate at least 4% since last Monday (and using last night’s closing prices): Kazakhstan (leading the way with a huge 26% devaluation following the removal of the trading band), Russia, Ghana, Guinea, Colombia, Belarus, Turkey, Malaysia and Algeria. In fact, if we extended the analysis to include those that have seen at least a 3% depreciation then the number of countries hits 17 and unsurprisingly all sit in the EM bracket.Every day it feels like we’re hitting fresh cycle lows for a currency somewhere with yesterday’s highlights being the Turkish Lira briefly sliding past 3 against the Dollar for the first time ever, the South African Rand breaching a level not seen since 2001, the Ruble weakening to the lowest level since February and the Malaysian Ringgit returning to a 17-year low.
So whatever their intentions the Chinese have created an air of fragility around the globe. Markets will now surely have to firm up considerably for the Fed to pull the trigger next month. We stand by our long-term view that they’ll struggle to raise rates this year but acknowledge that if calm does breaks out they wouldn’t require much to pull the trigger.
And PNB:
Rather than the ‘managed float’ that the last week’s regime shift seemed to tantalisingly offer, a dirty peg to the USD at 6.40 has quickly emerged. In the short term, the only real difference is that whereas the daily fix used to be fixed to determine the spot, the spot rate is now fixed to determine the daily fix. Plus ca change! Perversely, the role of the market in determining the value of the CNY has if anything been reduced rather than augmented…
Heavy intervention will mean an accelerated pace of FX reserve depletion will, in turn, means that the restrictions of the so-called ‘impossible trinity’ – any country’s inability to have capital mobility, a fixed exchange rate and independent interest rates – will also bind more, not less, tightly in the short term.Falling FX reserves reduce base money and so tighten domestic liquidity and push up short-term interest rates unless sterilised either by offsetting domestic asset purchases or loans or a larger portion of the pre-existing stock of FX reserves being unsterilized by reductions in reserve requirements.
Underlining the likely scale of intervention, the PBoC injected RMB150 billion (c.USD23bn) into the banking system over the last week; comfortably the most since the heavy seasonal demand period of the Chinese New Year. Further sizeable injections are likely. A cut in reserve requirements, rumoured as early as last weekend, is also unlikely to be far away. Like the Red Queen in Alice in Wonderland, the authorities’ are now having to run faster and faster just to stand still it seems given the upward pressure on rates!
…As many central banks in the past have found, data highlighting the scale of FX reserve depletion can often serve to further intensify depreciation expectation as the ‘costs’ of intervention become clearer to market participants raising ‘time inconsistency’ concerns. China’s enormous pile of FX reserves mean that heavy intervention can be sustained comfortably for a long time, although, of course, not indefinitely. A monthly rate of depletion of USD100bn, for example, constitutes about 3% of total reserves.
… exit from the new de facto USD peg of c.6.40 looks increasingly problematic with few obvious catalysts to staunch capital outflows and depreciation expectations other than a grim determination to hold the (new) line by the authorities until they hopefully subside. Decisively better macro-economic news would of course help but there is little, if any, sign of this on the horizon in the near term.
Nor will it come as investment flows out of emerging markets, commodities fall but developed markets do not have the demand to pick up the slack despite the income windfall. Households and businesses there will it save not spend it.
And so, as global growth slows and commodity prices keep falling, increasingly now owing to fading demand as well as oversupply, we await the credit event that will freeze debt in either emerging markets or commodities or both. From Russell Napier via Finanz and Wirtschaft:
How do emerging markets cause a global problem?
Some of the emerging markets borrowed massively in foreign currency in the past. The rapid depreciation of their currency creates solvency issues. If there is a significant default in the emerging markets, we are a facing a global crisis. The last thing the world needs in times of slow global growth is a credit crunch. But such a credit crunch somewhere in the emerging markets is very likely.Do we face a remake of the Asian crisis 1997/98?
Asia is the wrong focus. One big issue that led to the Asian crisis was the high level of foreign currency debt in relation to GDP. Most of Asia today doesn’t have as high levels of foreign currency debt to GDP as in 1997/98. The exception is Malaysia, probably because of its large oil company Petronas. The country faces similarities to 1997/98. But the rest of Asia is fine, they can let their currency devalue without having solvency problems.If Asia is not the problem, what emerging markets are at risk?
The focus should be on Eastern Europe, less on Latin America and Asia. Eastern Europe is completely different. Some countries there will default. It is just a matter of time. They borrowed too many Euros or Dollars. Turkey for example owes 400 Bio. $ to the rest of the world.What could be the trigger for a credit crunch in emerging markets?
I have learnt from history that it is very hard working out what the trigger is. In 2008, it was the collapse of Lehman Brothers that triggered a credit crunch. Now it could be a major event in Turkey or a default of the Brazilian oil company Petrobras or some event in Malaysia. But if I have to pick one I would say it is Turkey introducing capital controls. Such controls will mean that Turkey will not pay back principals amounting to 400 Bio. $ and the interests on it.Couldn’t the damage of a major default in Turkey be contained?
We saw in the past that when credit stops to flow to one big emerging market, it tends to stop flowing to all of them. In Eastern Europe, there are lots of countries with large current account deficits and currency links to the Euro. They need to be importing capital, but I fear it will stop flowing there.You worked in Hong Kong, when Malaysia imposed exchange controls back in 1998. What are the lessons?
When Malaysia imposed capital controls, capital flows instantly stopped everywhere in the region as people reassessed the risks associated with investments in emerging markets. The banks had been pricing the risks far too low. It also showed that politicians can completely change the default risks with one single decision. When a country borrows foreign currency and gets into troubles it has two options: Either paying it back to the expense of the local people or not paying the foreign creditors for the benefit of the local people. Most politicians chose not to pay.The US central bank is preparing for a rate hike. Don’t you think the Fed-officials will have to change their mind given the external headwinds?
I don’t believe the Fed will raise rates even though the economy is adding jobs and producing a little bit of wage growth. But a lot of the income growth goes into savings. I think this is driven by demographics. At the same time, the US economy faces a lot of external challenges including a dramatic decline in the oil price and a stronger dollar. The markets will soon realize that the economy is not turning up to a high level of consumption like the one we associate with the past 40 years of US economic history. Therefore, the Fed will not raise rates. If we find ourselves in the scenario with solvency issues in emerging markets, the Fed could even go back to quantitative easing or at least to opening swap lines to emerging markets.Zero interest rates for longer or even a bond-buying program sound like good news for equities. Could developed market equities go up and shrug off the possible problems in emerging markets?
No, absolutely not. Another asset purchase program by the Fed will not help this time. It’s like if you are lying in the hospital and the doctor says «The good news is you are getting more medicine. The bad news is it does not work.»But so far, quantitative easing, known as QE, has helped to push stock prices up.
Yes, it did, but the goal of QE is to push up nominal GDP growth. That should eventually reduce the debt to GDP ratio. What we are observing now across the world is the failure of that kind of policy. Once people realize that failure, equity markets will come down because so much money has been bet on the functioning of that policy. People are going to realize that boosting nominal GDP is not the way we bring down the debt ratios. It leaves us with much more painful ways to to reduce debt, such as austerity, allowing for defaults or massive political manipulation of various prices in the market places.The almightiness of central banks will gradually be challenged?
Exactly. The recent move of the People’s Bank of China and the decision by the Swiss National Bank to scrap the floor back in January have something in common. They are evidence that the central banks are not succeeding.Where should investors put their money in that environment?
I recommend only cash and high quality bonds.
I’m not so sure on the impacts of QE4. Napier will be right if it comes too late, after whatever credit event transpires to freeze the emerging market and debt commodity complex. If it comes before then the Fed might be able to reverse capital flows. Then again, without such an event, how can they reverse into QE4?
And so the implications for Australia ahead are:
- lower interest rates;
- a falling Australian dollar;
- rising bank funding costs culminating in a probable freeze;
- ongoing falling terms of trade;
- a falling stock market as the titans of mining are routed and banks tumble on credit contagion fears;
- diminishing Chinese capital flows once the above gathers steam;
- a household shock that will freeze the property market, and
- a sovereign downgrade as the Budget falls apart on all of the above, exacerbating the lot.
Australia was the place to put your money during the emerging market and commodity super cycle boom.
Now it is going to experience the polar opposite.
