This thought-provoking argument from Gavekal Dragonomics, an emerging-markets (EM) research outfit, is worthy of attention.
For years, markets have become accustomed to the global-imbalances school of thought – excess US dollar liquidity and consumption, fuelled by the irrepressible EM bid for US treasuries – as a driver of the global crisis, but is the reverse also true?
Would a substantial fall in the US current account, and associated US dollar shortage overseas, spark an EM rout? And was this the driver for this year’s rout?
The historical precedents suggest so, as per this sobering chart:
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Here’s the argument from Charles Gave of Gavekal Dragonomics:
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Hence, a worsening US current-account deficit creates more global liquidity, while an “improvement” reduces the amount of liquid funds sloshing around the world. During my career, all international financial crises have occurred against the backdrop of an improving US current-account deficit as evidenced by the first chart. |
Gave reckons the improvement in the US current account is principally down to the undervaluation of the US dollar, which has effectively been on a downtrend since 2002:
| It is noteworthy that this is only the third time since the start of the floating exchange rate system in 1971 that the US current-account deficit has improved in the absence of a US recession. The previous cases were 1988-1989 against the backdrop of German reunification and Japan’s bubble, and during the 1997 Asian crisis. There were periods when the rest of the world was booming. This is not the case today, which implies that the improvement is due to an undervalued US dollar. In fact, the US trade balance – stripping out oil and China – has provided little relief to emerging markets ex-China since the US current account has “improved” by an amount equal to 4% of GDP since 2006. But all of the improvement has taken place against the rest-of- the-world grouping, while the China and energy cohort has remained more or less constant (energy down, China up). The chief losers in the post crisis adjustment have been those “weak link” economies – Turkey, India, Indonesia, South Africa and Brazil – which have run significant current-account deficits. The impact of the US current-account adjustment has been to reduce this rest-of-the-world grouping’s output by an amount equal to about 4% of US GDP. To make matters worse, they must fund current-account deficits with US dollars, which they are no longer earning. Those emerging markets faced a Hobson’s choice: they could try to fill the funding gap by engaging in a fire sale of assets (including foreign-exchange reserves), or reduce their deficits by killing demand (and thus imports) through bruising interest rate hikes. Not surprisingly, most of them took the latter route. As a result, their financial markets and currencies have collapsed. |
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A basic purchasing-power-parity model appears to confirm the view that most G10 currencies, with the exception of the SEK and JPY, are over-valued relative to the dollar:
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| Source: Bloomberg |
The upshot of Gave’s argument is the EMs ex-China have inevitably run up current-account deficits thanks to weak US demand and now the chickens are coming home to roost. Gave elaborates on the mechanics:
| If the US current-account deficit exceeds what private-sector entities within reciprocal economies need for working capital, then part of this flow will move to reserves held by foreign central banks. And these reserves will be deposited back at the Fed to finance US budget deficits. This circle of dependence was described by the French economist Jacques Rueff as the “imperial privilege”. However, if the amounts generated by the US current account are insufficient to meet overseas nations’ needs, then those economies will, as already outlined, be forced to either borrow dollars (not a long-term solution), flog domestic assets or run down foreign-exchange reserves. Hence, when I see central bank reserves deposited at the Fed falling, I know that we are getting close to a “black swan” event, as dumping these precious “savings” is, for any country, always a desperate last resort. This is the pattern which started to unfold last July. But in the intervening period a most unusual pattern has unfolded. Central bank reserves held at the Fed (ex-China) have fallen, while the number is rising when China is included. |
He adds that the implication is China during the past six months captured the whole pool of global liquidity from the US current account. This view correlates with JPMorgan analysts, who estimate a cumulative capital outflow of $100 billion since last May out of 22 EM economies – ex-China and Middle East.
By contrast, China appears to have attracted a similar $100 billion of capital inflow over that period, Nikolaos Panigirtzoglou, lead author of the bank’s benchmark Flows and Liquidity report, concludes.
In other words, for all the noise, China has benefited at the expense of other EMs – though by upping its US Treasury purchases and, thereby, moderating the upward move in the global risk-free benchmark, China, in theory, has boosted investors’ desire for EM yield.
More broadly, the US current account is roughly in balance with the rest of the world ex-China, says Gave, posing real liquidity challenges:
| The problem is that the rest of the world must find dollars to buy energy, conduct trade settlement and service dollar debts. Those who are short of dollars can in theory get a swap from the Fed, or at least a renminbi swap from the People’s Bank of China which allows them to settle their trade with China. Practically speaking, most big emerging economies have not sought out such arrangements (or they were not offered) and so they instead stuck with the conventional approach of suppressing domestic demand. |
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Gave reckons the market backdrop, from an improving US current account, is foreboding, in part, because it correlates with bear markets in the MSCI World Index and recommends clients should invest in assets with positive dollar cash flows.
Gave – who has been a dollar bull for years – makes an interesting point that the US economic recovery is unusual since it is not associated with US current-account deterioration, and an improvement in the latter is historically correlated with EM crises.
George Magnus, economic adviser to UBS, and a veteran observer of EM crises, has made a variant of this argument, warning of a threat to the EM business cycle thanks to the prospect of US dollar strength, historically a harbinger for the Latin America and Asia crises.
A stronger US dollar, accompanied by higher US real rates and slower trend growth in China, threatens to trigger a “disorderly unwinding” of portfolio flows to EMs and credit-negative current-account weakening, he argued last year – a prospect that ultimately materialized, though the jury is out on the drivers.
Clearly the fact the US recovery is less consumption-intensive compared with the last two Fed tightening cycles in 1994 and 2004 is a disappointment for EM exporters.
However, Gave is possibly over-stating the case that an improvement in the US current account in and of itself is the trigger for an EM liquidity crisis.
Karthik Sankaran, a former EM fund manager, says: “I have an issue with the argument the US has to run a current-account deficit to fund the world. Just look at the US pre-1962, the UK pre-1915 and the German mark inside the European exchange rate mechanism.
“That said, a world in which the US is running smaller current-account deficits and US’s net capital outflow to EM are also smaller will get some people in trouble, especially if they’re on the wrong side of currency mismatches. This might be more true of the corporate sector than of sovereigns.”
A couple of other points:
1. The relative appeal of Japan as a net capital outflow country is greater now given the soft outlook for US portfolio flows. (This is one technical reason EM sold off heavy in May as hot-money, looking to pre-empt Japanese real-money flows, left developing markets disappointed these flows failed to materialize.)
2. The jury is out that higher real rates – in an attempt to close current-account gaps – in dollar-hungry EM deficit nations will cause a generalized demand shock (though it’s a risk in Brazil, Turkey and Russia) or that a cost-of-capital crisis that will pose systemic risks for the corporate sector.
3. In any case, there is little to worry about in terms of spillover impacts, given the fact vulnerable EMs ex-China form a small part of global output, suggesting the Fed has little to fear.
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| Source: Lombard |