Sudden Stop in Emerging Markets
“I can’t stand up for falling down”
—Elvis Costello
Emerging markets don’t emerge. I always tell this to my students. The emerging markets of today are the same countries that I studied when I was in school.
There are many reasons for this1 statement but I will narrow it to one main, albeit highly complex, driver: using short-term foreign currency revenues to finance local investments in domestic currency. Cyclicality of commodity revenues and dependence on export growth generate periods of exuberance where politicians and policymakers ignore the risks of the cycle, entering large periods of excessive investment with questionable economic return only to face an abrupt loss of foreign currency revenues when the cycle turns. This makes boom and bust cycles more severe, and the ability to recovery from recessions is slower and more complicated. As financial crises become more frequent, as we showed before, the emerging economy’s possibility of lifting itself from recession becomes harder and longer, but the impact on its main customer markets reduces its ability to recover when growth resumes.2
The sudden stop happens when emerging markets get used to an extraordinary and artificial increase in capital inflows and foreign currencies. Using that unexpected capital, foreign exchange reserves rise dramatically and large investments are financed with long-term debt issued to a market hungry for yield and growth. Then, suddenly, when the placebo effect of QE halts, there is an abrupt flight of capital out of the emerging economies.
The risk in emerging markets is not only lower-than-expected growth but also the abrupt disruption in the flow of capital investment.
One of the consequences of monetary stimulus in recent years was an extreme inflation in risky assets. The United States exported inflation to semidollarized economies and emerging markets, and some of the favorite investments throughout the monetary expansion times were emerging market bonds. Suddenly, with the prospect of the Federal Reserve reducing its stimulus, a wave of unprecedented withdrawal of capital occurred.
Reserves of emerging markets’ central banks fell by 10 percent, but financing needs increased by 7 percent and current account deficits widened.3
Excessive inflation and the collapse of local currencies made current account deficits soar in Latin American countries. Inflation soared to fiveyear highs in many developing markets.
The access to cheap credit and easy money created a liquidity excess of around $10 billion per month for emerging economies.4 And this excess became a new norm: an inflation of nearly 150 percent in risky assets.5
Unfortunately, periods of excess liquidity were not used to reduce imbalances and strengthen economies, but were assumed to be a new paradigm of normality. Until the tide turned. See Figure 4.1.
The sudden stop.
The impact on economic growth and stability in emerging countries can be very relevant. The combination of high inflation, current account deficits, and loss of dollar reserves by central banks has never been a winning equation. And the three variables deteriorate very quickly.
Figure 4.1 Abrupt fall in Emerging Markets Capital Flow in 2013
Source: IMF.
Indonesia lost 13 percent of its foreign reserves in three months, Turkey, Ukraine, and India showed similar figures. This is important because for many countries it is essential to hold enough dollar reserves ahead of uncertain times and financial difficulties.
Many of these countries and their companies have debt in dollars and if they hold less U.S. currency to meet their commitments, the country enters rapidly into a debt crisis.
However, when the sudden stop arrives, if central banks decide—correctly—to preserve their foreign currency reserves, devaluation hits homes and families, and inflation soars. The accumulation of imbalances generated by getting used to artificial injections of liquidity always ends in recession and high inflation.
Since 2009, Brazil, China, India, Russia, Turkey, and others have sold more than $2 trillion in bonds, mostly to American mutual fund companies.6 As this money flowed into their countries, financing skyscrapers, massive dams, and oil exploration, economies and currencies strengthened. But then the reverse occurred, led by a slowing Chinese economy, and as that money headed for safety, local currencies collapsed.
The BIS economists warned of the consequences if panicked bond investors decided to sell these positions at the same time.7 On one side, bond funds have become so large and own so many of the same securities that a bond-selling panic can spread quickly and the price loss be more severe because the liquidity dries and the bonds become harder to sell.
About $340 billion of debt maturities accumulated between 2016 and 2018. The total payments due each year during the period is equivalent to the net bond sales by nonfinancial companies in developing nations in 2015. The danger is that once credit becomes less available, borrowing costs will rise and make it more difficult for companies to refinance their debt, according to the BIS.
The economic instability of many of these countries was not a topic of discussion at the Federal Reserve meetings throughout QE1, 2, and 3 until the world became concerned about the collapse of the Indian rupee in 2013. Many saw the risks to be small, but with soaring inflation and a widening current account deficit, risks started to arise in many other countries.
A sudden stop always has global effects. It had a relevant impact on European banks, heavily exposed to Latin America, and on multinational companies, as well as very important direct consequences in British and U.S. banks, because of their exposure to Asia and Africa. But above all, it creates challenges for developing countries with increasing refinancing needs, if they cannot access the capital markets after the boom years of the Fed “easy money.”
“Significant emerging currency depreciation should cause investors to hesitate. Depreciation is a secondary form of “default.”8
Can a sudden stop be avoided? Yes, by avoiding the previous unprecedented rise—instead of falling in the liquidity trap, using foreign currency as a tool to boost real productive investment. But which government is going to support this? When G20 countries, with a longer history of transparency and governance, fail to center capital expenditure on productive projects with real economic return9 and resort to white elephants and unproductive debt, how could we expect anything different from any other government?
What Happens When the Tide Turns? The U.S. Dollar Becomes the New Gold
The wakeup call that the end of QE, first, and the rise in interest rates afterward, in 2016, have meant for global asset classes should not go unnoticed as a warning sign for the future.
Above all, these changes have large implications on the cost of debt. No one can say they had not been warned, but many governments and investors preferred to think that the Federal Reserve would continue to play the monetary laughing gas game to perpetuate imbalances that were accumulated for 16 years.
Remember that an entire generation of market participants had only seen “Buy the Dip” strategies aimed at following the “bad news is good” policy of riding the central bank wave.
This central bank-led madness brought an accumulation of more than $11 trillion in negative-yield bonds. Suddenly, a small rise in inflation expectations could create potential losses exceeding $1 trillion.10
The vacuum effect in the United States makes the strong dollar, supported by a small rise in interest rates, absorb liquidity from all over the world back into the United States—capital flight out of commodities and emerging markets.
In China, several companies were forced to cancel relevant bond issues due to volatility when investors demanded much higher rates. China lost 20 percent of its foreign currency reserves in 2016. This is normal; if the U.S. 10-year bond rises to a required yield of 2.5 to 2.6 percent, no one in their right mind would accept risk in countries and areas of high volatility whose differential with that U.S. bond does not compensate the risk.
The strength of the U.S. dollar and the slight rise in U.S. rates led the Chinese sovereign 10-year bond yield to two-year highs in 2016. In two days,11 Chinese sovereign bonds saw the biggest price drop in eight years in the five- and ten-year bonds, leading the Chinese regulator to halt trading in futures due to some capital outflows.
Such a rise in rates and an increase in risk would not be a huge problem—after all, they are still very low rates with 3.5 percent in the 10-year bond—if China had not embarked on the brutal orgy of debt. In the 12 months, China “stabilized” its slowdown with a monstrous increase of 11.4 percent in money supply (M2) for a GDP growth of 6.2 percent with a worrisome housing bubble. Total credit granted increased in 2016 from 246.8 to 265 percent of GDP, seven months after the Chinese government announced measures to “contain” excess borrowing.
The global implications of this Chinese risk are important.
Those who argue that all this cannot continue to happen, because China accumulates more than $1.2 trillion of U.S. bonds, are wrong.
First, because China has been reducing its U.S. bond portfolio for years and had at the end of 2016 the lowest figure since 2013.
Second, because—contrary to popular belief—the main buyer of U.S. bonds is not China, but U.S. investment funds and the U.S. citizens themselves. If China were to dispose of its entire U.S. bond portfolio, the U.S. market would absorb it in just over two weeks.
I believe this could happen by 2020; the Chinese are considering blockchain technology such as Bitcoin along with Gold and all the other traditional options to avoid the impact on wealth of large devaluations. Chinese were querying the blockchain exchange owners in 2016 on how much wealth new blockchain asset classes such as bitcoin could handle in a single day.12
The China–U.S. issue is important because it leads to a spiral in which the world’s old growth engine is in evident slowdown and faces the serious problem of losing a significant part of the more than $250 billion annual trade surplus with the United States if they both enter a commercial war.
In 2016 China saw capital outflows of almost $1 trillion. These capital flights erupted in a year in which the Chinese economy added more debt than the United States, EU, and Japan combined.
The Chinese bubble was exploding in slow motion and companies and savers expatriated as much capital as possible—either via acquisitions or directly with deposits—ahead of an increased risk of massive devaluations.
A country that needed four times more debt per unit of GDP growth in 2016 than in 2008 showed a clearly unsustainable model. By 2016 China’s total debt ballooned, led by semistate-owned companies and the housing bubble. China already spends almost 3 percent of GDP on interest payments.
The devaluation of currencies against the U.S. dollar showed again that the Keynesian dogma that a weak currency leads to more exports is simply incorrect.
The U.S. dollar became the new gold in the face of mounting evidence that the “beggar-thy-neighbor” policies and drowning structural problems in liquidity came to an end.
There are many who think that the U.S. economy cannot tolerate a strong dollar. I do not agree. The United States only exports 12.6 percent of GDP, and less than 30 percent of the profits of the S&P 500 come from exports.13
Praying to the mantra of monetary expansion and devaluation will not work if the U.S. economic policy with a new administration is aimed at strengthening the domestic market, increasing disposable income for the middle and lower classes, and ending the perverse incentives created by years of failed demand-side policies.
We should be waking up from a model based on unicorns of Keynesian multipliers to a new global paradigm where the largest and most powerful economy conducts supply-side policies.
Ignoring that this option even exists shows us how hypnotized we are with the mirage of growth by decree and the inexistent wealth from monetary expansion. But, at the very least, the world should be prepared for the growing possibility that the placebo effect of monetary laughing gas is a thing of the past.
“Trumponomics” and the End of Currency Wars
The victory of Donald Trump in the U.S. elections was a shock to the mainstream media. More than 80 percent expected a clear victory from the Democratic candidate, Hillary Clinton. Clinton exemplified the perpetuation of demand-side policies conducted by Barack Obama and a reaffirmation of the status quo.
Donald Trump, on the opposite side, presented a combination of supply-side reforms, tax cuts, and “Buy America” policies.
The unprecedented tax cuts that were announced added to a more protective policy toward industry, and messages on renegotiation of trade deals and “Make America Great Again” were supported by the World Bank, which predicted that these reforms could “accelerate global growth,”14 and Deutsche Bank, which stated:
“We believe that the election of Trump as the 45th President of the United States will fundamentally re-order the economic, financial, and security arrangements of the post-WW2 era, and we believe that these changes will have a significant impact on the economic performance of nations, industries, and corporates across the globe.
The defining feature of Trump’s economic approach is likely to be a rebalancing of the policy mix away from the exclusive reliance on easy monetary policy toward a more balanced reliance on deregulation of economic activity, supported by an expansionary fiscal policy as a means to jump-start the U.S. economy. Incidentally, this is the same policy rebalancing that we and others have recommended for the eurozone for a number of years now. This policy will be successful in moving the U.S. economy away from low-growth secular stagnation toward significantly more buoyant performance. We would not be taken by surprise by a doubling of the growth rate of real GDP in the United States over the next two years, nor by a further significant move up of equity valuations and a material further appreciation of the dollar.
The business background of many of the key members of President-Elect Trump’s new cabinet makes it highly likely that there will be a strong and concerted emphasis on lifting the heavy regulatory burdens imposed on the U.S. business sector by the outgoing administration. We expect quick progress in reforming the corporate tax system and in rationalizing the regulation of energy, finance, environment, healthcare, labor markets, and the welfare system. These policies should help raise productivity enough to make higher growth rates sustainable in the long term after the initial stimulus wears off.
We expect the new administration to remain true to an America First approach, relying on bilateral rather than multilateral deals in trade and foreign policy. This is a United States that will be prepared to take risks, and that will re-evaluate existing arrangements under the lens ‘What’s in it for the United States’—rebalancing some benefits toward the United States. This approach should produce a new order that will ultimately be more stable in the sense that ‘good fences make good neighbors.’ However, we do note that the uncertainty about the Trump administration’s policies is still large, as is the reaction of those impacted by these policies. In particular, while a strong protectionist turn by the United States is not our central scenario; such an outcome would be disruptive for global trade.”15
There are numerous papers that support the view that the tax cuts and deregulation would help jump-start the U.S. economy.
The overwhelming evidence16 shows that growth is more likely to accelerate by cutting corporate taxes than by spending.17 Adding the proposal to repatriate up to $1 trillion of multinationals’ overseas dollar accumulation—which at the end of 2016 exceeded $2.5 trillion—would also be beneficial for the U.S. economy. A $1 trillion infrastructure investment program, financed entirely by private capital with tax deductions, would be a huge relief to the deficit with a boost on output. Although fiscal multipliers of infrastructure spending are debatable in an open economy, there is merit to the idea in the United States where infrastructure investments are clearly required.
Reducing the excess cost of healthcare, cutting red tape, and boosting disposable income through tax cuts is probably the best solution to secular stagnation.
Empirical research, from Mertens and Ravn to Alesina and Ardagna, Logan, and the IMF,18 concludes that in more than 170 examples in history tax cuts impact growth more positively than does spending.19
In Trump’s case those cuts mean that citizens with annual income lower than $25,000 will not pay income tax; those making less than $75,000 will pay10 percent; those making between $75,000 and $225,000, a maximum 20 percent; and those making above that, a marginal tax rate of 25 percent. This is the biggest tax cut in history.
Corporate tax would be lowered to 15 percent, with a 10 percent repatriation tax on funds accumulated offshore. Goldman Sachs estimates that the United States could repatriate more than $1 trillion with this policy.
How will these tax cuts be financed? By improving public spending efficiency, repealing and replacing the Affordable Care Act, cutting red tape, and reducing most public spending items by 1 percent a year.
The administration plans $1 trillion in infrastructure projects that would be entirely financed with private sector funds, paid via tax credits, tolls, and fees.
Some question the plan. The Peterson Institute estimated $2.85 trillion lower revenues in ten years from the tax reform, and $1 trillion of higher defense spending, leading to a 25 percent increase in debt.20
On the other hand, others21 estimate that the plan could even reduce debt.
In my own analysis, debt would fall by cutting spending by 1 percent per annum on oversized plans, which would create $750 billion savings in 10 years. Revenues from corporate tax would not fall, but stay unchanged in real terms due to the increase in economic activity and repatriation of U.S. firms’ foreign investments, while wage increases would increase tax revenues. Debt to GDP would decrease with a small increase in inflation, higher growth at 2.8 percent per annum, and achievement of energy independence in 2019—eliminating barriers to exploration and production also increases real investment. Finally, the hoover effect of inflows of capital into the United States and outside of emerging markets would strengthen the economy.
After years of currency wars, one of the least talked about proposals of the Trump administration is the one that aims to penalize with economic sanctions those countries that manipulate their currency ... even the United States.
The proposal is not entirely new, and has been defended by Republicans since 2014, but the novelty is in the penalization of monetary manipulation.
On the one hand, Republicans have two proposals, one in the House of Representatives Financial Services Committee and another in the Senate Banking Committee, by which the Federal Reserve would be prevented from making decisions on interest rates and balance-sheet expansion if they deviate by more than two percentage points from a predetermined Taylor Rule.
If the Federal Reserve targets a level of inflation and employment for a level of rates and monetary policies, it would have to explain to Congress or the Senate why it changes or deflects the normalization when these targets are met.
Very few representatives of the Republican Party deny that the dramatic cut in interest rates led to a huge bubble that generated the 2008 crisis, and that prolonging the so-called expansive policies in recent years has generated another bubble in bonds and an excess of euphoria in financial assets with no discernible impact on the real economy.
As we mentioned before, the indiscriminate creation of money not supported by savings is always behind the greatest crises, and there is always someone willing to justify it as both a problem and its solution.
Add to this that the economists of the Federal Reserve and its chairpersons were all unable to alert or even recognize the risk of such bubbles—from Greenspan22 to Bernanke23 or Yellen24—and you will understand why there is a growing body of politicians concerned about monetary policies that are always launched as if they had no risk and then justified with the lame argument of “it would have been worse.”
Of course, the Federal Reserve rejects such limitations.25 However, the model used to justify the stance that following a Taylor Rule would have impacted 2.5 million jobs is questionable to say the least, as it assumes a direct correlation between interest rates, money supply and investment, and job creation that simply does not work. Torsten Slok states: “If the Fed in 2008 and 2009 had followed a Taylor Rule then they would most likely have responded in the same way as they did.”26 But market participants would have been less prone to risk on the view that the Fed would do “anything.” We know this because it is the way the market strategy changed after QE3.
When the central bank becomes the largest hedge fund in the world under the premise that there is “no inflation” despite a massive bubble in financial assets, it is difficult to change the methodology of the entity. But after it consistently erred on estimates, impact, and consequences, it is normal that the Republican Party and many Democrats put the mandate of the central bank in question.
Carl Icahn, one of the world’s top investors and Trump’s appointed regulation adviser, still holds the napkin where he took note of the Federal Reserve chairman’s response to his question on whether they had gauged the negative consequences of the Fed’s monetary policy. “We don’t know,” was the answer.
But what is interesting is the idea of penalizing countries that implement devaluation policies of beggar-thy-neighbor after the currency war seen in recent years. But the United States cannot prevent central banks of other countries from continuing to impoverish their citizens through devaluations and brutal increases in money supply ... unless they are fined for doing so. And that penalty can have dissuasive effects and, in addition, prevent the generation of larger bubbles that lead us to another financial crisis.
It is not about returning to the gold standard. In fact, what this group of representatives of the Republican Party demands—and in that they are right—is the end of uncontrolled monetary excess without any responsibility for its consequences—rejecting a system that encourages bubbles and overindebtedness under the excuse that “it could be worse.”
We do not know if these measures will be implemented, but it is important and healthy that the debate over the excesses of central banks is raised at government level in the world’s leading economy. Trump himself, who once said that “America can print all the money it needs,” abandoned that ridiculous comment.
In any case, just as the crisis of 2008 ended the excesses of some financial operators, it is time to alert that central banks’ balance sheet cannot be used indiscriminately as if they were high-risk funds to perpetuate bubbles, when the result has been more than disappointing.
Recovering a little sanity, even modestly, will not hurt anyone.
1 Emerging Markets, Prospects and Challenges. Kalpana Kochhar, IMF, Oct 2013.
2 The effect of financial crises on potential output: New empirical evidence from OECD countries. Davide Furceria, Annabelle Mourougane, Journal of Macro-economics, 2012 Volume 34, issue 3.
3 In 2013, the Taper Tantrum, when the U.S. Federal Reserve stopped its asset purchase program despite continuing with ultra-low rates.
4 Additional liquidity above historical average, Goldman Sachs, 2013.
5 EM index rise 2009 to 2013.
6 Moody’s.
7 www.bloomberg.com/news/articles/2016-08-18/bis-flags-emerging-market-risks-as-340-billion-of-debt-matures
8 William H. Gross, 30th July 2015.
9 What Keynes Really Said about Deficit Spending. Elba K. Brown-Collier and Bruce E. Collier. Journal of Keynesian Economics, Vol. 17, No. 3 (Spring, 1995).
10 Estimated losses of a rise in inflation 1 percent above bond yields, Goldman Sachs 2016.
11 December 2016.
12 Driven by Chinese and Indian buyers escaping the risk of devaluation and demonetization, Bitcoin reached an all-time high of $1000 in December 2016.
13 2016 figures.
14 Trump Tax Cuts Could Jump-Start Global Economy, World Bank, January 2017.
15 David Folkerts-Landau, Chief Economist, Deutsche Bank, January 2017.
16 Tax Foundation. Tax Cuts and Growth http://taxfoundation.org/article/what-evidence-taxes-and-growth#_ftn7
17 Various papers support the evidence: Taxing Top CEO Incomes www.aeaweb.org/articles?id=10.1257/aer. 20151093 “Technical Change, Wage Inequality, and Taxes,” Laurence Ales, Musab Kurnaz Christopher Sleet www.aeaweb.org/articles?id=10.1257/aer.20140466
18 http://taxfoundation.org/article/what-evidence-taxes-and-growth#_ftn7
19 Tax cuts vs. Spending www.wsj.com/articles/SB10001424052748704271804575405311447498820
20 Peterson Institute for International Economics, analyzing Hillary Clinton’s and Donald Trump’s economic plans, 2016.
21 CFRB, Committee For Responsible Federal Budget.
22 www.nytimes.com/2010/03/19/business/economy/19fed.html
23 www.washingtonpost.com/wp-dyn/content/article/2005/10/26/AR2005102602255.html
24 www.thetimes.co.uk/tto/business/markets/us/article3922666.ece
25 medium.com/@neelkashkari/taylor-rule-would-have-kept-millions-out-of-work-9ab31fd826bf#.tccy11vcs
26 “Audit the Fed legislation,” 2nd January 2017.