Saturday, 1 February 2014

Unravelling the global effects of mad money

Since some of my 'work' observations on currencies have been doing the rounds in the press over the last few days, I thought I'd lay out some broad thoughts on recent weakness in emerging market (and other) currencies. There's a danger in broad generalisation in a quick sweep through thirty years of the after-effects of very low US interest rates, but this is a blog not a research paper so here goes....

In 1993, when the Federal Reserve maintained interest rates at what was then perceived to be an astonishingly low level of 3% as the US economy recovered from the aftermath of the S&L crisis and the recession two years earlier, the seeds were sown for the 1990s Asian crisis.

When the central bank of the world's biggest economy decides that its domestic interests are best served by extraordinary monetary policy settings, policy-makers all over the world have to decide how to react. In 1993, by and large, Asian policy-makers' response was to continue to gradually liberalise the flow of money into and out of their economies, to maintain formal or informal pegs between their currencies and the US dollar and to let the good times roll. In countries like Thailand, the decision not to allow currencies to appreciate pretty much automatically resulted in US interest rates being imported into economies which were growing far too fast for 3% rates. What followed was a surge in both domestic credit growth and in foreign currency borrowing - if your central bank sets rates at 6%, the Fed is at 3% and you have a fixed exchange rate between your currency and the US dollar, why not just borrow cheap dollars?

The result through the early part of the 1990s was that a lot of Asian countries maintained competitive exchange rates and saw very rapid growth in credit. That was fine for a while but as US interest rates rose, it became problematic. It became clear to everyone that what looked like a credit 'boom' was a bubble and that too many golf courses, casinos and beach resorts had been built without regard for whether there was income enough to service the debts to pay for them - debts whose services costs were going up.

As growth slowed, bad debts ballooned and capital left their countries, Asian central banks found that they did not have enough currency reserves to stop the pressure on their (pegged) exchange rates, and were forced to choose between letting them fall (making the foreign currency debt problem worse), raising interest rates (causing an even greater economic downturn) or imposing capital controls. Different countries chose different paths but the Asian crisis followed and the next few years were spent trying to learn the lessons from the disaster.

The lessons which were learnt served Asia well in 2001-2012. As the Federal Reserve once again embarked on a policy of exceptionally easy monetary policy after 2000, Asian central banks were much more alert to the danger of poor lending practises and to the danger of foreign currency borrowing. They set about building vast war-chests of currency reserves to help defend themselves against future runs on their currencies. And they started to allow their currencies to float somewhat more freely, which mostly meant that they allowed them to appreciate against a US dollar anchored by low interest rates.

Because they avoided the worst excesses of credit growth in this period, Asian economies weathered the 2008 crisis much better than Europe and the US. But what came out of that period was even lower interest rates (3% Fed Funds in the 1990s become 1% Fed Funds in the 2000s and then zero Fed Funds in the 2010s) with the added twist of Quantitative Easing.

The challenge remained the same and was no longer in any way an 'Asian' problem or even one just for 'emerging' economies. The central bank of the world's biggest economy set interest rates at zero when the emerging market economies as a whole were enjoying real GDP growth of 7 1/2% in 2010. They faced the choice of allowing their currencies to appreciate sharply, of allowing domestic asset prices to rise and credit to grow because rates were too low, or of imposing capital controls. No wonder many complained they were in a currency war.

Different countries faced different domestic issues and reacted to the global environment in different ways. But if there is a common thread it is that most allowed their currencies, in nominal and even more in real terms, to appreciate more than they had in the early 1990s.  In 1993, a young backpacker wandering the world would generally have found that 'emerging economies' were cheap places to visit. By 2011, that was no longer the case. Again, it was not just an 'emerging market' story. In 1995, British people could go and enjoy cheap prices for winter sun in Australia, while young Australians came to London to earn better pay than they could get at home and see the world at the same time. Now, Australia's youth stays at home to serve beer to locals who enjoy watching their cricket team thrash England's.

When the notion of the Federal Reserve 'tapering' its bond purchases was first mooted last May, there was a temptation to ask whether that was important. Buying bonds more slowly is only a marginal shift and interest rates are still at zero, after all. However, a turn in the monetary policy cycle was signalled and was enough to trigger a violent response in asset markets. US bond yields rose and the currencies which had been allowed to appreciate in reponse to super-easy US monetary policy, started to fall back, chaotically in many cases.

The most positive way to look at the events of the last 9 months is that most of the central banks whose currencies are falling, probably welcome at least part of the adjustment. They didn't choose to have overvalued exchange rates, after all. What they chose was to allow the currency to take the strain of offsetting US monetary policy, which in turn allowed them to maintain some degree of control over domestic credit conditions. If I compare the modest sell-off we have seen in emerging market bonds, for example, with the larger moves we have seen in currencies, the conclusion is that the currency is doing its job of acting as a shock-absorber and this is a currency adjustment (so far) and not a crisis. In Australia, whose currency is now 20% cheaper than it was at its peak, there is no sense of crisis at all. In Argentina whose currency has fallen almost 20% in January, it's definitely a crisis.

Whether it is right to conclude that there is 'no crisis' is a matter of judgement. But I would draw three very broad conclusions:

Firstly, the willingness to allow currencies to act as a shock-absorber helps prevent the extremes of domestic credit imbalances which plagued Asia in the 1990s. That is a very good thing indeed in those countries which did allow their currencies to float more freely and did manage their domestic financial system more closely.

Secondly, given that we are still in the very early stages of the US policy nomalisation and since there are still an awful lot of countries whose currencies are far more expensive in real terms today than they were 10 years ago, it would be rash to assume that the adjustment is mostly complete.

And thirdly, since Fed policy was even more accommodative in this cycle than in the early 2000s or the 1990s, it isn't surprising that the scale of the capital flight from G3 economies into the rest of the world was much bigger this time and the accompanying asset inflation was also much greater. And so, the turmoil that can be caused by those flows being reversed, can also be greater than it was in the second half of the 1990s. Which is to say that even while I don't think this IS a crisis at this point, the risk of it becoming one is clear. Particularly in those countries where control of domestic asset inflation and credit creation was weakest.

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