Sunday, 9 February 2014

The Grand Old Duke of Rio

The emerging market sell-off paused for much of last week but the debate about what it all 'means' rages on.  So to carry on from last weekend's themes here are a few points and a picture:

Firstly, a re-cap: really low rates (and QE) in the US (and Europe) caused a huge flow of money into almost any asset with any yield both in 2004-2008 and 2009-2002. Secondly, many (not all) central bankers allowed the effects of this to be felt in 2009-2012 through currency appreciation, a major difference with the 1990s. Some of them ended up with very expensive currencies. The US ended up with a very cheap one. Thirdly, many (but definitely not all) EM countries were consequently able to avoid the explosion of debt, notably foreign currency debt, that they suffered from in the 1990s. In aggregate, foreign currency debt is a smaller share of EM exports today that it was a decade ago and the interest that is paid on it totals something like 2 1/2% of export earnings. Fourthly, it isn't the US' 'fault' that the Fed sets a domestic level of interest rates that works for the US but doesn't work for the rest of the world. And finally, I think it would be very useful if we stopped talking EM and DM, and at the very least took China out of EM and started calling it the world's second biggest economy with the world's biggest domestic credit problem. It makes a mess of 'EM-wide' data if it isn't considered separately and if China's debt bubble does burst, I for one won't describe the outcome as an 'EM crisis'  

Anyway, here's a chart of real effective exchange rates, some EM and some DM, back to 2005. I drew it to keep my mind occupied for the last hour of a truly awful game of football yesterday and I'll do some 'work' on this theme in the next few days.  The data are from the BIS, and I've updated them as best as I could in the time I had. With any index-based look at FX, the starting point is arbitrary and therefore prone to skewing conclusions if you're not careful, but I chose 10 years ago because that was far enough after the 1990s EM crisis for recovery to be underway, and far enough after the Euro's launch for EUR/USD to have both collapsed and recovered. So for better or for worse, this chart shows how real exchange rates have moved since the global economy was in a relatively balanced state, in the early stages of the great financial bubble.

A few things are interesting. The first is that towards the end of 2012, the three cheapest currencies on this arbitrary list and relative to my arbitrary starting point, are the dollar, euro and pound. The second is that three currencies saw truly staggering real appreciation in 2004-2008 and then again after 2009:  The Chinese Yuan has appreciated by 40% in real terms over a decade. The Brazilian real had at one point almost doubled in value in real terms and even now is still 50% more expensive than it was in 2004. Go to the World Cup, and experience what that means for yourself. The Rouble too, is 40% more expensive in real terms than it was. If you are in Sochi, you probably realise what that means. But at the other end of the spectrum, whatever else is going wrong in South Africa, the rand has replaced the pound as the biggest FX faller in this list over the last decade, the Turkish Lira is correcting fast and the whole EMFX boom, in real terms anyway, rather passed the Mexico Peso by.

Perhaps it isn't surprising given the trend above, that the current account balance of the developed economies as a whole, should have improved by over USD 400bn per annum over this period. The developed economies now have a combined current account surplus. And by contrast, the surplus of the emerging and developing economies has, of course, shrunk. Indeed, in all probability some time this year the current account balance of 'EM' will be in deficit if we exclude China.

The shift in the balance of payments reflects in part the real appreciation of EM currencies and the real depreciation of the two most important developed economy currencies. But that still doesn't automatically mean that EM disaster in upon us. In 2007, just before everything went wrong, the EM world had a $600bn current account surplus, but an even bigger inflow of private capital, almost USD 700bn. The other side of that coin was a USD 1.2trn increase in EM central banks' currency reserves. Madness! We all thought everything would change after 2008 but in 2010-2012, the total private sector inflow into EM was $1.5trn, and FX reserves grew by another $2trn to mop as much of that up as possible.

So much investor capital has flowed into EM overall that the global financial system is inherently unstable and prone to the kind of volatility we are seeing. Really, am I supposed to be shocked by weekly flow data that show money still coming out of EM funds?

More facts: External debt of EM economies has risen from around $3trn in 2005 to about $7trn now but as  a share of exports, that total is actually down slightly from 80% to something a little above 75% today. It's above 100% GDP in Latin America and the CIS while in Central and Eastern Europe it's north of 150% of exports. It's around 50% of exports in Asia.

Finally, the big hornet's next is the growth of domestic debt, and this is a global rather than an EM problem. There is much debate about whether deflation is here, whether it's bad and whether there are good and bad kinds of deflation. The kind of deflation that will cause us all trouble will be the kind that results in nominal growth rates being too low to prevent debt/GDP ratios heading inexorably upwards. That's the biggest challenge facing Japan, Europe and as Chinese growth slows while debt grows very quickly, it will be more than a headache for the world's second biggest economy.

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