The Real Source of Emerging Market Stress

Trade wars have little to do with it
By Daniel Lacalle, Chief Economist, Tressis Gestión
July 9, 2018 2:18 pm Last Updated: July 11, 2018 1:43 pm

Last week, emerging markets experienced the highest outflows since September 2015. Even the Chinese market and its currency have completely roundtripped from the January highs.

The reason: Emerging markets, according to the Bank of International Settlement, have more than doubled their debt issued in U.S. dollars in the past decade, reaching an all-time high of $7 trillion including derivatives.

Wait a minute. If a country with monetary sovereignty can issue all the debt it needs in local currency without the risk of default, according to modern monetary theory, why do emerging economies need to issue in U.S. dollars? Are they incompetent?

No. Their own economic agents and international investors do not want bonds in local currency or demand extraordinary yields, because all these savers know they cannot trust the local currency, whose purchasing power is consistently destroyed by increasing the money supply to finance government deficits.

What happens is simple. Few savers accept debt in a constantly depreciating currency to finance government excesses.

Monetary Fallacy

The fallacy of monetary sovereignty and “this time is different” synchronized growth has become evident in the past months with a very moderate and widely anticipated rate hike in the United States. The increase in interest rates was announced repeatedly, just like the reduction in the Federal Reserve balance sheet, but many chose to ignore it.

This “extend and pretend” strategy led to widening deficits and increases in debt and now the most evident symptom of stress, currency devaluation against the U.S. dollar.

Until recently, China seemed immune. Despite the massive capital controls and policies to keep the yuan artificially strong, the local currency has collapsed against the U.S. dollar, losing all its 2018 gains in two weeks, and down on the year.

Even strong capital controls cannot prevent outflows forever. Risk builds slowly and then everything happens fast. The news of constant bail-outs, defaults, and less investment in fixed capital became leading indicators of a more pronounced slowdown than expected.

So what is happening has little to do with trade wars and a lot to do with the unwinding of the excessive risk built in the past years.

Chinese Devaluation?

China might decide to devalue as the least-hurtful way to mitigate its internal challenges, but it will not solve them. However, if that happens, the impact on global markets can be severe. We already saw what happened the last time the yuan dropped only a few percentage points, in a surprise move in August 2015.

The sell-off in financial markets was widespread and aggressive. However, that was short-lived because U.S. money supply kept rising and rates remained low. Now, the risk of a China devaluation, which is not discounted at all by markets, needs to be added to the reduction in money supply from the United States and its rate hikes.

When liquidity tightens, there is a natural flow to the center of gravity, U.S. dollar assets. This, in turn, helps the U.S. economy, which is strengthening, and U.S. consumers benefit from a stronger dollar because imports become cheaper.

The United States knows a weak dollar is not in its interest in the current part of the cycle. To strengthen the U.S. economy, which exports very little, it needs a stronger dollar and more inflows of external capital to finance its deficits.

China, on the other hand, needs to end its capital control policy. It prevents its currency from being a true worldwide one, and it does not help its position as a global leader. The yuan cannot be a world reserve currency and a contender by maintaining capital controls and poor transparency. As China rejects loosening its grip on capital flows, even if it does not work, it is damaging its options of attracting more foreign capital and making its currency a store of value.

This market is not weakening due to trade wars; it is weakening due to the hangover of currency wars.

US Still No. 1

Almost every country decided to massively increase debt and money supply because the United States did it, too. They just forgot that none of them issues the world reserve currency. And now we live in the aftermath of monetary excess.

Of course, the United States led in monetary excess after the crisis, but the market is a relative game, not an absolute one. Governments and economists may react angrily at the fact that the U.S. dollar and Treasury bills are the least risky assets. They might think it is unfair. I do not care. It is a fact. The market assigns a higher risk to the other bonds and currencies, and there is a reason for it.: history and experience.

While the United States maintains capital investment and private property as pillars of its economy, it is more than questionable in other nations. If the U.S. economy is strengthening and the other major economies are slowing down, the reversal of fund flows is inevitable, even if rate hikes are moderate.

Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP. 

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.