Sunday, 3 February 2019

US Drivers of Emerging-Market Volatility

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.
[5] For a detailed presentation of the methodology, refer to Scott R. Baker, Nicholas Bloom and Steven J. Davis (2016), “Measuring Economic Policy Uncertainty,” Quarterly Journal of Economics, Volume 131, Issue 4, and Steven J. Davis (2016),“An Index of Global Economic Policy Uncertainty”, University of Chicago Booth School of Business.