Societe Generale’s Albert Edwards is known for his bearish commentary of financial markets, and he has been spot on more than a few times over the last two or three decades. Edwards has not done so well over the last few years, however, as he has been unsuccessfully calling for a major correction in the current long-in-the-tooth bull rally in U.S. and many global equities for some time now.
In his July 30th Global Strategy Weekly (and it seems timely based on today’s news), Edwards lays out the bear case for many EM equity markets, saying it is time to pay the piper for many countries, as they have been garnering their economic growth from devaluing their currency rather than actually improving economic productivity. Edwards highlights the 1997 Asian currency crisis as an example of why central bank currency intervention is no economic “free lunch”.
Albert Edwards on the perils of currency intervention in emerging markets
In the introduction to the section, Edwards emphasizes "the causal relationship between swings in EM FX reserves and their boom and bust cycle." He then goes on to argue that the "1997 Asian crisis demonstrated that there is no free lunch for EM in fixing a currency at an undervalued exchange rate."
He goes on to explain that after a few years of an export-led boom, market forces continue to take their course as boom turns into bust as the balance of payments slate moves from surplus to deficit. When a currency is intentionally undervalued by central bank policy, both current accounts and capital accounts surge to surpluses before long. Over time, the balance of payments surplus forces the central bank to intervene in the foreign exchange markets to keep the currency undervalued. Of note, this pattern was seen both in the mid-1990s and before and after the 2007 - 2009 financial crisis.
Edwards goes on to note: "Heavy foreign exchange intervention to hold an EM currency down creates money and is QE in all but name and underpins boom-like conditions on a pro-cyclical basis."
Moreover, the economic boom is also accompanied by rising inflation and an increasing real exchange rate even though the official rate might be fixed. Over time, competitiveness is lost and the trade surplus declines or turns to a deficit. Capital account can also turn deficit as direct investment flows reverse as the countries have become less cost effective locations for business operations.
Ultimately as the balance of payments swings to deficit and foreign exchange reserves fall, this in effect creates a "negative QE", slowing down an economy and leading to capital flight.
In concluding, Albert Edwards points to several signs pointing to the fact that the current EM boom/bust cycle is just now gathering steam and rolling towards the "bust" phase. "As a virtuous EM cycle turns vicious (like now), commodity prices, EM asset prices and currencies come under heavy downward pressure - at which point it is difficult to discern any longer the chicken from the egg. In my view the egg was definitely laid a few years back as EM real exchange rates rose sharply and the rapid rises of FX reserves began to stall."