The emerging markets crisis has three causes

Today’s commentary

On Friday, I wrote about the slowdown in China, the bear market in commodities, and the volatility in emerging markets as being all interrelated. Of course, there is more to the selloff in emerging markets than just the slowdown in China and commodity prices. Much of the problem is political and has to do with macro imbalances in particular markets. But the perceived tightening in the US and now the UK has also brought a new risk-off source of volatility as well.

Just reviewing here, last week I wrote a series of posts on China and the impact of slowing growth in China. The first was “Gauging China’s growth”, followed by “Australia: Is this the end of the natural resources boom?” and a post on the Canadian housing market as I felt those two developed markets were most impacted by a China growth slowdown. And then I wrapped it up Friday with some thoughts on the slowing of Chinese growth and the rout in commodity currencies.

The thesis here is that China is serious about rebalancing its economy. And it will therefore grow slower and it is therefore less dependent on commodities.Because Chinese leaders are always willing to socialize losses if necessary, this takes away tail risk in China over the medium-term but it doesn’t diminish tail risk for economies connected to China – including Germany, which has re-oriented exports to the country. In developed markets, Australia and Canada are obviously affected. But outside of the developed economies, a host of emerging market commodity exporters will take it on the chin as well. Those which have the most imbalanced economies will feel the most pain.

On the commodities side, I identified Brazil, Argentina and South Africa as three countries at particular risk. Argentina and Brazil have unbalanced economies with large current account deficits and rising inflation. South Africa is in the midst of serious civil unrest and union strikes that make the country appear increasingly less stable though the strikes themselves have merit

But commodities problems are not all that we are seeing. The realization that tapering IS tightening in the US has led to risk off and caused portfolio preferences to shift against the emerging markets. And to make matters worse for EM, the UK has also signalled tightening by abandoning forward guidance. What investors should note is that unemployment has fallen faster than the central banks in the US and the UK imagined it would. In the face of this news, their previous forward guidance tells us they should switch to a tightening bias. But the time inconsistency of monetary policy has them saying something else now because tightening now doesn’t suit their needs. The guidance was wrong then. Meanwhile, both banks are unwilling to shift guidance and admit they got it wrong. The Fed is in turmoil over how to finesse this while the Bank of England has simply given up forward guidance as a principal policy tool. Either way, markets have less information about how and when rates will rise and must therefore assume the lack of guidance is a de facto tightening.

When the Fed first tightened by mentioning tapering, EM sold off violently. Particularly hard hit was India, with its budget and current account deficits. This time – now that the Fed has actually tapered and the BoE has abandoned forward guidance – a larger selloff seems to be underway. You have the commodity currencies selling off including in developed economies. But we now also see the countries with large macro imbalances or weak political regimes like Turkey and Thailand selling off. The question is whether the rout in countries with serious problems leads to a general sell off across emerging markets and that looks to be a possibility.

For example, The Malaysian Ringgit has fallen to a three-year low, despite there being no obvious large imbalances in the domestic economy. Bloomberg paints the problems in Malaysisan markets as being connected to EM problems more generally:

The yield on Malaysia’s five-year sovereign debt climbed for a fifth day and the benchmark stock index fell the most in five months, as a devaluation in Argentina’s peso deepened risk aversion. While inflation picked up in December to the fastest pace in two years, the central bank will probably keep its benchmark interest rate at 3 percent on Jan. 29, according to all 16 economists surveyed by Bloomberg.

“Sentiment is bad,” said Nizam Idris, head of strategy for fixed income and currencies at Macquarie Bank Ltd. in Singapore. “People are still worried about Argentina, the Federal Reserve’s tapering, and China’s shadow banking is unravelling.”

And indeed the Chicago Board Options Exchange Emerging Markets ETF Volatility Index rose 40% to 28.26 last week. This is a EM-wide sell off of currencies, bonds, and equities that tells you contagion is a factor. The Polish Zloty is also folding under pressure, and this is the currency of a country which mastered the European sovereign debt crisis in stellar form. So the fact that we have this widespread kind of selloff tells you we have contagion. Right now this is just a mini-crisis. My view here is that a serious deterioration in a weak link like Argentina or in a large economy like India or Brazil will make this a full blown crisis.

Mike Shedlock sees this playing out as the latest instalment in the currency wars. Japan’s desire to inflate and depreciate its currency may have led to the latest episode. But as far as the tapering source of crisis goes, all evidence is the Fed will not relent. Things will have to get well out of hand for the Fed to do so – and that means that the US economy would have to tank and bond yields would plummet. At that point, the Fed would signal risk on and the EM currencies could stabilize somewhat – though the commodities rout would still be a big factor in pulling them down.

Ultimately, this is what happens when you have unfettered capital flows centered around a monetary system that lacks any sort of mechanism to stem external imbalances. The dollar standard post-Bretton Woods is a flawed monetary system, all the more so because the accumulation of US dollars as reserves guarantees current account problems between the US and its main trading partners. Let’s hope the current crisis settles down soon. If it doesn’t, the overdue correction in equities will be on us and bonds will outperform.

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