A growth-led dollar bull run for at least the next two years is on the cards, raising the spectre of an emerging market crisis, George Magnus, economic adviser to UBS, has warned.
In a February 25 report, Magnus fires a shot across the bows of emerging market bulls, who cite strong relative growth prospects, long-term currency appreciation pressures and asset base expansion as reasons why emerging markets can withstand volatility in the US exchange rate and government yields.
He argues 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 emerging markets and credit-negative current account weakening. He writes: “It seems complacent to imagine that the capital flows that have poured into emerging market real estate, local currency bond and equity markets, and piled up in their central banks, will be benign when they reverse as the US dollar appreciates. If the idea of a strong US dollar becomes more widely shared, this is likely to be a trigger of financial instability, much as it was in the previous two bull market cycles [1978-1985 and 1992-2001].”
The strong dollar call is somewhat counter-intuitive given Bernanke’s reassurance that Fed extraordinary stimulus will remain until the labour market recovers, fears over fiscal sustainability, political gridlock and low US yields.
However, Magnus strikes a sanguine tone on the US fiscal picture, citing Congressional Budget Office (CBO) figures: “The budget deficit under current laws will drop to under $500 billion in 2013, or 5.3% of GDP, the lowest since 2008. The central forecast, based on an undemanding GDP growth rate, is that it will continue to drop to 2.4% of GDP by 2015.”
He notes that the CBO predicts that fiscal and debt sustainability issues for the US are “unlikely to become pressing until later in the decade and the 2020s”, adding “if the deficit should halve in the next two years, as suggested, sentiment in US capital markets is likely to be buoyed, for a while at least”.
Magnus reckons a QE exit could be on the cards this year to normalize credit conditions and close the output gap, estimated by the OECD at 3% compared with the 2% to 3% projected economic expansion this year. In sum, he argues decent growth, a decline in the energy trade deficit, monetary tightening, structural euro and yen weakness, as well as higher US bond yields, all pave the way for a seven-year dollar bull run until 2015 at least. (The US dollar index, which measures the greenback against a basket of six currencies, hit its trough in March 2008.)
He concludes: “Even if you want to reserve judgement about the prospects for US fiscal politics, energy independence and leadership in advanced manufacturing, the US dollar may still appreciate against other major currencies. The US economy is, relatively speaking, in better cyclical and structural shape, the Fed will likely be the first central bank to exit QE, and the US dollar faces weak competition in the rest of the developed world.”
For the past decade, the US exchange rate has shaped emerging markets’ investment prospects, with a weak dollar, indicating a loose Fed policy, feeding the global money supply and reducing the cost of funding for carry trades and portfolio shifts to higher-yielding bond, equity and currency markets, while boosting commodity prices, a boon for EM exporters. The correlation between the nominal US dollar trade-weighted index against global risk and EM flows between 2005 and 2010 is striking, as chart 5 lays bare:
Hot money
Fears have been raised that hot money inflows into emerging markets have been financed, in part, by QE, during the past four years, and depressed short-term US yields, threatening a correction in the event the Fed tightens monetary policy with higher inflation and weaker EM currencies. However, Magnus’s argument suggests the prospect of a financial crisis in EM is more structural in nature, driven by dollar strength.
Although few emerging market currencies are over-valued, intra-Asian trade is growing and external dollar-denominated debt is low, dollar strength could trigger a sharp contraction in domestic credit supply in emerging markets, he argues.
“The reason we should expect some sort of flare-up is that there are grounds for economic caution, based around weakening trends in exports and current account balances, and strong credit growth, which, among other things, has helped to fuel significant asset inflation, especially in real estate and local fixed income markets,” says Magnus.
Relieved of the pressure to boost competitiveness by intervening in the forex market, central banks are likely to normalize funding mechanisms in the event of a stronger dollar. This shift will drain domestic liquidity compared with strong-dollar conditions, since central banks’ operations to sterilize their exchange-rate interventions are typically inadequate, a boon for domestic credit supply.
“[Dollar strength] could give central banks the opportunity to try to unwind funding mechanisms, such as the extensive use of required bank reserves, and sterilization operations, which are believed to have contributed to the faster expansion of off-balance sheet and shadow banking, especially in China, and to the dominance of the central bank in what are more sophisticated but still often immature and shallow local financial markets,” he says.
The greenback’s strength, combined with a slowdown in China, could wreak havoc on commodity prices and the Bric investment thesis, though a crisis is not imminent, Magnus concludes. “Credit expansion has always been a poor and ultimately risky alternative to structural and political reforms, but this is the direction in which public policy has tilted since 2007," he says. "When the credit cycle eventually rolls over or is brought to a more abrupt end [cue stronger US dollar?], some countries may face more significant political challenges related to income inequality, and a more equitable distribution of the income and benefits flowing from economic development.”
Nevertheless, the consensus view among investors and sell-side analysts is that the relationship between dollar strength and emerging market risk appetite is not necessarily mechanistic during normal market conditions with EM flows increasingly correlated with growth prospects and risk appetite, untied to the US exchange rate.
Magnus, an influential economist – a veteran of the emerging market crises in the 90s and early 00s – reckons the backdrop for emerging markets is foreboding, in part, because the US dollar bull run contributed to the Asia crisis. Between 1995 and 1997, emerging Asian currencies strengthened relative to the yen, which, in trade-weighted terms, had depreciated 50% against the dollar, triggering a growth-negative Asian competitiveness shock. Meanwhile, the Latin American debt crisis in the 1980s was caused, in part, by the rising cost of debt servicing thanks to US dollar strength.