By Stephen Jen (via Itau Global Connections).
Bottom line: We are likely to be at least several months too early in writing about the risk of a ‘sudden stop’ undermining some EM currencies and assets. Capital continues to flow into EM, in size, pushing up many of the EM currencies. But we are increasingly worried about the risks of a ‘sudden stop’ in these capital flows. In recent years, the cumulative capital flows into EM have been so large (the cumulative stock of foreign inflows to EM are more than twice as large as those on the eve of the Lehman Crisis) and so low in quality that the longer the developed central banks maintain exceptionally aggressive monetary policies, the bigger the risk of an ultimate unwind of these cumulative flows into EM. The potential triggers of such an unwind, in our view, could be (1) an inflection point in the Fed’s policies and (2) a sustained rally in the dollar. This risk may not be imminent, but it will become more significant over time. The scope for further downside for USDEM is limited. If anything, over the coming months, the risks are skewed to the upside, in our view.
Massive cumulative capital flows into EM. Capital flows into EM in the last decade have been substantial in size, in absolute terms, relative to past history, as well as in percent of the GDP of the recipient countries. The chart on the left below (please refer to the attached pdf) shows the profile of capital flows into the various parts of EM. Here are some summary figures. In the four years leading up to the Lehman Crisis in 2007 (2004-07), cumulative capital flows into EM totaled some USD 3.1 trillion. This amount was substantially higher than the cumulative total of USD 800 billion registered during the prior four years, 2000-2003. During the GFC (Global Financial Crisis), capital flows heading into EM collapsed, though they did not turn negative. The mere decline in the capital flows, however, led to some very sharp movements in EM currencies. For example, during the GFC, USDKRW surged by 57%, EURPLN rose by 51%, and MXN depreciated by 55% against the dollar. There was no crisis in any of these countries. But their currencies exhibited crisis-like trajectories.
In the four years since the GFC (2009-2012), the cumulative capital flows into EM totaled USD 3.9 trillion – even larger than the four years leading up to the GFC. Thus, the cumulative stock of foreign capital flows into EM is more than twice as large now than it was prior to the GFC.
In terms of capital flows by region, Emerging Asia has received by far the largest inflows (USD 2 trillion during 2009-12), followed by LatAm (USD 980 billion) and Emerging Europe (USD 646 billion). While in absolute dollar terms capital flows into EM have been huge in recent years, as a percentage of the GDP of the recipient countries, the size of these inflows has been less than during 2006-07 but more than during the early 2000s. Inflows have been declining in proportionate terms, due to the buoyancy of nominal GDP (in dollar terms) in emerging economies.
History of ‘sudden stops’. A ‘sudden stop’ is an abrupt reversal or stoppage in capital flows that may lead to sharp currency depreciations in the recipient countries. These events can be very disruptive for the recipient countries mainly because i) economic activities funded by these capital inflows would suddenly need to seek alternative funding sources; and ii) the central banks of the recipient countries will be pressured to sell their reserves to meet this demand for foreign currencies, and often central banks are reluctant to fully meet this demand, partly because interest rates in the recipient countries experiencing sudden stops could spike higher, leading to economic costs.
We assume our readers are familiar with the sudden-stop literature and therefore we will not review the details. We do think it is useful, however, to look at the experiences of sudden stops during the LatAm Crisis of the 1980s and the Asian Crisis of 1997.
The LatAm Crisis. During the 1970s, many Latin American countries were experiencing booming growth, and the routes to borrowing from foreign creditors were open and easy. However, debt and debt service began to accumulate at a rapid pace, spiraling out of control by the late 1970s. The bulk of LatAm debt was in USD, and as the Fed hiked U.S. interest rates in the early 1980s (in order to curb the oil-based inflation of the 1970s), the real exchange rates appreciated significantly, which only intensified the situation and made the debt repayment more difficult. However, as demand was still high in LatAm, U.S. banks continued to increase their lending during the years leading up to the outbreak of the crisis. With Mexico’s announcement in 1982 that it was unable to service its debts, this led the majority of Latin America (including Mexico, Brazil, Venezuela and Argentina) to reschedule its debts as well. The international financial community reacted badly to this news and pulled out of LatAm as a region.
The Asian Crisis. The 1997 Asia Crisis arose from a combination of dangerous financial and economic conditions: fixed or semi-fixed exchange rates, large current account deficits (which created downward pressure on these currencies), and high domestic interest rates, which gave incentive to companies to borrow offshore. On top of this, they borrowed heavily in international markets and in currency, leaving their economies prone to the effects of a strengthening dollar. With the rapid appreciation of the U.S. dollar causing the Asian currencies to become overvalued, currencies devalued, and capital flight ensued.
What could happen a year from now? Large and fickle capital inflows into EM are problematic because the flows could reverse, and given the immense size of the cumulative flows witnessed in the last decade, we are concerned about the risk of a sudden stop. Here are some thoughts.
— The ‘Global Currency War.’ There are two broad aspects of the discussion on this subject: prescriptive and descriptive. The prescription portion has to do with the G20 consensus on countries not showing the intent of distorting currency values in the conduct of monetary policy, avoiding the rhetoric of referring to specific numerical exchange rate targets, and abstaining from actual interventions to influence the exchange rate. However, just because the G20 have reached an agreement on the acceptable conduct of monetary and exchange rate policies, it does not mean that all would be fine if these guidelines are followed. This is the descriptive part of the discussion, showing that there are negative externalities that the G20 consensus does not deal with. As the reserve-currency-issuing central banks conduct QE, the liquidity exported to EM has made the recipient countries vulnerable to a sudden stop. The money-printing central banks say that they are not responsible for these negative side effects on other countries. The problem is that the EM economies aren’t able to absorb these inflows properly. When the Finance Minister of Brazil accused the Fed of having started a Global Currency War, we presume he did not mean that the U.S. manufacturers were gaining an unfair advantage on the Brazilian counterparts, but that the corresponding Fed liquidity would cause bubbles in Brazil and elsewhere.
— Capital flows of inferior quality. We made this point in our previous write-ups that, prior to the GFC, most of the capital flowing into EM were ‘pulled’ in by the perceived superior economic fundamentals of the recipient countries. However, post-2008, much of the flows into EM were ‘pushed’ out by the central banks printing money. Because of this change in the underlying motivation for the flows, we believe the flows in recent years are of inferior quality to the flows seen pre-2007.
— The Federal Reserve. The unconventional monetary policies are fully reversible and will be fully reversed when the economies normalize. This means that the type of capital flows ‘pushed’ out by the money-printing central banks – discussed above – are inferior in quality because they will also be fully reversed one day. This is an important distinguishing feature of the types of capital flows into EM pre- and post-GFC. Further, if this thesis is correct, then when the Fed normalizes its policy, there will likely be a meaningful reversal in capital flows from EM back into the U.S. As mentioned above, in the 1980s, it was the Fed’s innocent rate hikes that triggered the LatAm Crisis. At the same time, the dollar has been artificially depressed by the multiple rounds of QE by the Fed. It could appreciate sharply in the coming quarters. We recall that in the mid-1990s, it was the appreciation of the dollar (especially against the JPY) that dragged USDAsia higher, which ultimately led to the Asian Currency Crisis.
— CA deficits. Previously, sudden stops tended to be triggered by certain vulnerabilities of the capital recipient countries, e.g., a large CA deficit or an over-levered or otherwise vulnerable banking system. However, since only a few EM economies have relatively large CA deficits (e.g., India, South Africa and Turkey all have CA deficits in the 5%-6% of GDP range), we suspect a prospective sudden stop will likely be triggered by the ‘originator’ of the liquidity (e.g., the U.S.) rather than the recipient, as has normally been the case. Once there is capital flight, commentators will ex-post ‘discover’ the structural flaws that justify these outflows.
Bottom line. This may or may not be an immediate risk, but we believe the multiple rounds of QE conducted by the major central banks around the world in recent years may have significantly increased the risk of a ‘sudden stop’ in EM countries. Since the unconventional monetary policies will be fully reversed when the respective economies normalize, these capital flows are also likely to fully reverse one day. Given the size of the cumulative flows in recent years – around USD 7 trillion since 2004 – we fear that some EM currencies could weaken substantially against the dollar, when the Fed starts to reverse its policy stance. Without an actual crisis, some EM currencies could exhibit crisis-like price action.
Stephen Jen is the managing partner at SLJ Macro Partners.
Prior to establishing SLJ Macro Partners in April 2011, Stephen was a Managing Director at BlueGold Capital (since May 2009), working as the key risk-taker in currencies and as its macro strategist. Before BlueGold, Stephen was a Managing Director at Morgan Stanley and, from October 1996 to April 2009, held various roles, including the Global Head of Currency Research and the Chief Global Foreign Exchange and Emerging Markets Strategist. Prior to Morgan Stanley, Stephen spent four years as an economist with the International Monetary Fund (IMF) in Washington, D.C., covering economies in Eastern Europe and Asia. In addition, Stephen was actively involved in the design of the IMF’s framework for providing debt relief to highly indebted countries. Stephen holds a PhD in Economics from the Massachusetts Institute of Technology, with concentrations in International Economics and Monetary Economics. He also earned a BSc in Electrical Engineering (summa cum laude) from the University of California at Irvine. Stephen was born in Taipei, Taiwan, and now lives in London with his wife and two children.