The US Federal Reserve turned ´dovish´ recently, somewhat surprisingly. Does that mean that emerging markets (EM) will cheer? Or won´t we have other EM currency crashes in 2019, like in Turkey and Argentina last Summer? The last OECD
Economic Outlook (November 2018) stated recently that „Argentina and Turkey have been
experiencing severe financial turmoil. Rising tensions in these economies, in
the context of US monetary policy normalisation and idiosyncratic domestic
factors, led to a sudden change in market sentiment toward semerging-market
economies and triggered capital outflows.“[1]
EM cyclical fortunes
do depend on US monetary policy, largely via three channels: global interest
rates, the dollar, and global output. China, so far the global ´growth machine´, has become another cyclical determinant for emerging-market (EM) output, but so far mainly through trade,
raw materials and, until a decade ago, ´unlimited supply of labour´. However,
in historical perspective, the monetary shocks emanating from the US Federal
Reserve Board (the Fed) have been comparatively minor in 2018 (Figure 1). With
the Fed's recent dovish shift, the hunt for yield could be back; flows to EM
should be picking up sharply.
Fig.1: US Fed Funds Rate (blue) and US Dollar Index (red) 1974-2019
·
To be sure, the world´s single most important interest rate – the Fed
funds rate – did com back from the zero lower bound in 2018 in recent
quarters. However, in historical perspective, we are a long shot off the levels
reached in the early 1980s when the disinflationary Volcker shock led to the
Latin American, African and Korean debt crises. Even compared to the period
thereafter, the recent rise looks almost ´peanuts´.
· The trade-weighted dollar index has recorded annual
percentages changes of maximum +/- 15 % ever since the 1985 "Plaza
Accord" when G7 finance ministers reached an agreement about managing the
fluctuating value of the US dollar. The recent dollar surge in 2013 in the wake
of Bernanke´s paper tantrum caused quite a bit of (short-lived) havoc in EM
markets and raw material prices. With corporate balance-sheet assymetries
typical of EM, dollar volatility can be fatal[2].
Figure 2: A Tale of Two Currency Crashes 2018
- Currency
index, 1/1/2018 = 100 -
The Turkish
lira and the Argentine peso both crashed in 2018 (Figure 2), which immediately
let to contagion in some emerging countries, notably those who run deficits on
the current account and have a high dollar share in private and public debt.
That EM contagion remained comparatively limited and short lived, may be
attributable to market interpretation that the Turkey and Argentina crises were
home-made to a large extent. Note that the Turkish lira has recovered
quite well since August while the Argentine peso has stayed knocked down in
2018.
That Argentina and
Turkey crashed was predictable. Both countries were expanding their
current account deficits into a period of rising G-3 interest rates. Both currency crashes rather are variants of 1st generation currency crises as external budget constraints and solid FDI funding were ignored for too long:
· Argentina: In
Argentina, unlike Turkey, the big foreign currency borrower is the
government. Her twin deficits – fiscal and external – have been widening
from zero in 2010 to roughly 6% in 2018. While these number do not sound
outlandish – and nor is public debt as a percentage of GDP – Argentina´s debt rests on a
very narrow export base. Since the early 2000s, exports (and services) have come back towards 10% of GDP, from more than 20% in the 2000s. During the
2010s, “exports of bonds” have been gradually replacing exports of goods and
services[3].
Toxic.
· Turkey: In
order to maintain his rule via a strong economy, Erdogan used pro-cyclical
monetary and fiscal policies to fuel overall economic demand, after the global
financial crisis in 2009 and then again after the military coup in mid-2016. In
addition to generous money supply and high deficits in the state budget, public
loan guarantees for private companies fueled output. Infrastructure investment
was booming but increasingly debt-financed. Although private banks and
companies in particular have incurred increasing foreign currency debt, the private debt often
represents state contingent liabilities[4].
Figure 3: The Global ´Drumpf´ Effect
Beyond ´US monetary
policy normalisation and idiosyncratic domestic factors´ listed by the last
OECD Economic Outlook, we must look for another determinant that has recently
caused, is currently causing and will cause EM financial volatility: global
economic policy uncertainty. The Global Economic Policy Uncertainty Index has
reached extreme levels never measured since its creation. While Euro fragility
and the return of military tensions have certainly added to global uncertainty,
the shocks to the world economy caused by US President Trump's isolationism,
his obsession with containing China (the EM growth machine) and his willingness
to impose sanctions all over the world have driven the index to levels
displayed in Figure 3. Let´s call it the global ´Drumpf´effect. This is the
central source of EM market volatiliy for the foreseeable future, despite the
US Fed having turned dovish.
The Global Economic
Policy Uncertainty Index[5]
has thus reached extreme levels never measured since its creation. The index is
a GDP-weighted average of national indices for 16 countries that account for
two-thirds of global output. Each national index reflects the relative
frequency of own-country newspaper articles that contain a trio of terms
pertaining to the economy, uncertainty and policy-related matters: uncertainty
about who will make economic policy decisions, what economic policy actions
will be undertaken and when, and the economic effects of policy actions (or
inaction)—including uncertainties related to the economic ramifications of
“noneconomic” policy matters, for example, military actions.
In order to measure
various possible drivers of emerging-market volatility, Figure 4 compares the
indicators for the US dollar index, the Federal Funds rate and global economic
policy uncertainty index with their long-term average. For each price driver,
the distance between the current data point and the ten-year average was
plotted.
In order to be able to compare the distances, they were compared with the
respective standard deviation. Thus, the measurements are standardized with the
fluctuation of the respective time series. In statistics, the measure is called
the "Z score".
Figure 4: US Drivers of EM Volatility (z-scores), 2007-18
Figure 4 shows the
index of economic policy uncertainty at a level of fluctuation triple its
long-term average at the end of 2018. Although the Fed Fund rates has recently
started to rise, its standardized fluctuation is pretty much at long-term
average, while the strong US dollar has lifted its z-score to almost double its
long-term average. In sum, emerging markets need currently worry much more
about policies of the Trump administration than about the US Federal Reserve,
as far as global factors are concerned.
[2] V. Bruno and H.S. Shin
(2018), “Currency depreciation
and emerging market corporate distress”, BIS Working Papers No 753.
[3] B. W. Setser (2018), “Argentina: Sustainable, Yes, with
Adjustment. But Sustainable with A High Probability?”, Council on Foreign Relations,
21.5.2018.
[4] See my “Erdogan's macro populism is far from over”, ShiftingWealth, 30. 8.2018. In
contrast to other observers who saw Erdogan´s imminent demise in August last
year, I pointed to ´heterodox´ alternatives to IMF funds and capital controls
as lifeguards for the continuation of Erdogan´s populist rule.
