The Train Wreck In Emerging Markets; Carry Trade Junkies

width=”600″]emerging markets Bridgewater Associates, January 2014[/caption]

Bridgewater Associates, January 2014

In the first phase an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency.

In the second phase, the allure of continuing high returns morphs into a growth story and attracts ever-stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both, so that ever more inefficient economic growth depends increasingly on foreign capital inflows. Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitate capital flight.

In the third and final phase, capital flight drives a self-reinforcing cycle of falling asset prices, deteriorating fundamentals, and currency depreciation… which in turn invites more even more capital flight. If this stage of the balance of payments cycle is allowed to play out naturally, the currency can fall well below the level required for the economy to regain competitiveness, sparking runaway inflation and wrecking the economy as asset prices crash.

In order to avoid that worst-case scenario, central bankers often choose to spend their FX reserves or to substantially raise domestic interest rates to defend their currency. Although it comes at great cost to domestic growth, this kind of intervention often helps to stem the outflows… but it cannot correct the core imbalances. The same destructive cycle of capital flight, falling asset prices, falling growth, and currency depreciation can restart without warning and trigger – even years after a close call – an outright currency collapse if the central bank runs out of policy tools.

John and I believe that this worst case is the looming risk for many emerging markets today, particularly in the externally leveraged “Fragile Eight” (Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, and Turkey) and, in the event of a forceful unwind in the USD carry trade, maybe even China. Not only have those countries amassed a disproportionate share of total inflows to emerging markets, but each also has its own insidious combination of structural and political obstacles to long-term growth. Each of these countries is not without options, but the longer they delay in being proactive, the greater the risk.

The question for 2014 is, what happens when the tide of easy dollars reverses and reveals a more challenging funding environment?

With John’s blessing, I hope to profile each of the fragile emerging markets individually in the coming months and in our upcoming book (working title: Sea Change); but for now I have to limit our discussion to a couple of charts from a recent letter titled “Carry Trade Junkies,” by my good friend Josh Ayers at Paradarch Advisors, along with a few specific observations on three of the most fragile economies.

According to official data reported by the Bank for International Settlements and the IMF, Turkey, South Africa, and Chile look like obvious candidates for capital flight and are three of the leading currency-crisis candidates.

Not only do these economies rank among the most externally leveraged in the world…

External Debt to FX Reserves

Sources: Paradarch Advisors, BIS, IMF

… but their banking systems also rank among the most externally leveraged.

External Bank Debt to FX Reserves

Sources: Paradarch Advisors, BIS, IMF

In addition to enduring high levels of leverage that remain uncovered by FX reserves, Turkey, South Africa, and Chile are also liable to serious USD shock risk, based on their economic fundamentals (unlike Poland and Hungary, which are less likely candidates for immediate currency collapse given their very low levels of domestic inflation).

The lesson here is clear. The catalysts are already in position to spark an initial flight to safety if the USD moves just modestly higher.

Some economies (like Turkey, South Africa, and Chile) are more fragile than others (like Russia, Brazil, and India); but an initial wave of crises can push the USD higher and easily lead to larger accidents. The experience of the 1990s shows how, against the backdrop of a relatively strong US economy and policy divergence between major central banks, extreme stress in the emerging markets can lead to elevated US dollar strength, which in turn can trigger additional crises and push the world’s reserve currency to even greater heights. For example, the Mexican “Tequila Crisis” of 1994 played a role in pushing the USD higher and, along with Bank of Japan easing, helped trigger the Asian Financial Crisis in 1997. The Asian crisis, in turn, set off a sharp jump in USD strength and an equally sharp fall in oil demand, which, along with an oversupply of oil, contributed to a crash in oil prices in 1998 and threw Russia into crisis.

As the example of Russia shows – and the inverse relationship between the US dollar and oil prices highlights – this is not just a matter of capital inflows turning into outflows, but rather inflows giving way to outflows while the value of commodity exports falls simultaneously. So, this dynamic gets more and more dangerous for increasingly fragile economies as the dollar reaches new heights and commodity markets are stressed.

US Dollar Index vs. WTI Crude Oil

Turkey, South Africa, and Chile may be the likely “first wave,” which policymakers around the world may see as inconsequential… but it’s easy to see how that first wave could grow into a tsunami.

Financial Repression Backfires

When asked about the concept of financial repression (a technical term for policies that are intended to fuel a domestic wealth effect and force savers to take on more and more risk over time to maintain a manageable level of income), former Treasury Secretary (and recent Fed Chairman runner-up) Larry Summers recently commented, “I think the instinct to financial repression is there. But it strikes me that the world is pretty global and there are a lot of places to put money, and even if one wanted to financially repress, I don’t think that [in] most of the industrialized world is going to be that easy on a large scale.” (Click here & fast-forward to the 1:03:48 point to see his comments.)

It never made the nightly news, the front page of the New York Times, or even the news page on Bloomberg, but Summers’ comment is a tremendous revelation from the man who almost succeeded Ben Bernanke as Fed Chairman earlier this year.

By trying to shore up their rich-world economies with unconventional policies like ultra-low nominal interest rates; outright balance-sheet expansion; and aggressive, open-ended forward guidance, major central banks have dramatically widened international real interest-rate differentials and forced savers to seek out higher (and far riskier) returns for more than five years running.

But that money did not just move further out on the risk spectrum from low-yielding cash equivalents to higher-yielding assets like US stocks, high-yield bonds, and MLPs. In the process of fighting naturally deflationary impulses and forcing investors to take more risk, the Federal Reserve has also forced an enormous amount of money to move out of the United States and into the emerging world. The risks have been clear to policymakers all along, but emerging markets are well outside of the Fed’s mandate. They are collateral damage, so to speak.

In his latest issue of Global Macro Investor, Raoul Pal estimates that the resulting carry trade has grown to roughly $3 trillion into major emerging economies (excluding China) and nearly $2 trillion into China alone. My friend Mark Hart comes up with similar numbers for “unexplained inflows” by backing the sum of foreign direct investment and trade out from the total growth in FX reserves, and he discusses the situation at length in a recent “Master Class” interview with Raoul Pal on Real Vision TV. These are staggering numbers, even compared to the massive Japanese yen carry trade that had grown to roughly $1 trillion by 2007; and they add up, quite simply, to the Mother of All Carry Trades… which can unwind VERY QUICKLY in the event of a major US dollar rally. Shades of 2008.

That’s the flip side to years of low rates, QE, and aggressive forward guidance. The Fed buys time for the US economy to find its footing at the expense of rampant misallocation across the rest of the world. Major developed economies can adjust their policies to offset the effects, but the emerging markets find themselves in a far more vulnerable position as easy money masks the urgent need for reforms. And once the Fed reverses its policy to reflect relative strength in the US economy, it’s a bloodbath for economies that cannot adjust easily, which in turn pushes the US dollar even higher and starts to take a serious toll on real economies… like China’s, where state-sanctioned data dramatically understates the extent of the world’s most dangerous debt bubble.

In the days leading up to All Hallows Eve, the prospect for a US dollar rally should inspire more fear than any campfire ghost story or voodoo curse. This is a realistic and increasingly probable outcome; and the last time the world saw a series of emerging-market crises (first in Mexico in 1994 and then in Southeast Asia in 1997) against the backdrop of a weak Japanese economy and a relatively stronger US economy, it pushed the US dollar to such heights that it triggered a 50% collapse in oil prices, pushed Russia’s economy over the edge in 1998, and blew a hole in the side of a highly levered hedge fund, Long Term Capital Management, that nearly brought down the global financial system.

The next round of policy divergence could be far more destructive than that, because this time the global financial system is far more levered; instability is far more widespread; and the amount of money required to backstop an accident will be greater than the Fed’s entire bloated balance sheet. These are the logical consequences of post-2008 financial repression, and they’re the reason why emerging-market central bankers like Raghuram Rajan are calling loudly for better coordination of global monetary policy.

It is indeed every central bank and country for itself, and that is a recipe for volatility and financial losses. If you think this story has a happy ending, you are not paying attention to history.

Geneva, Atlanta, and New York

I write this at the end of a very packed four days of constant mental stimulation. The Barefoot Summit at Kyle Bass’s ranch in East Texas was up to its usual high standards. And due to the rain we have had all summer, East Texas is about as pretty as I have ever seen it. And the weather was perfect. It was a great setting in which to sit and talk all things macro. Sen. Tom Coburn was in attendance (along with a few other political types), and I find him to be a thoroughly delightful and thoughtful man. I am sad to see his wisdom leave the Senate but understand the personal reasons. We need more men like him in government.

And while the weather in Boston was not initially welcoming, it has turned absolutely beautiful today. Niall Ferguson and his team at Greenmantle have put together a most thought-provoking conference. The gathering was held under strict Chatham House rules, so while I can share my thoughts about it, I can’t describe the actual conversations or the people involved without their permission. As you might expect of a man with Niall’s resources and connections, he was able to pull together fascinating panels and presentations of the highest quality. We were treated to in-depth analysis of almost every region of the world as well as to presentations of new ideas and technologies; and the forum was small enough to allow for very active debate.

Tomorrow I fly to Washington DC and then on to Geneva for a few days of meetings and some time to gather my thoughts before returning to Atlanta for a day before I finally head back to Dallas in time for Halloween.

I’m going to go ahead and hit the send button without my usual final comments, as I want to get to the gym and there is a full evening planned for tonight. You have a great week.

You’re more convinced about a dollar bull market than ever analyst,

John Mauldin