By Stephen Jen (via Itau Global Connections).

Bottom line: We believe most EM currencies are vulnerable to material depreciations against the dollar in the coming months. The relatively weak run of data in the U.S. in recent weeks may or may not postpone the talk of tapering, and, as a result, the recent weakening in the EM currencies may or may not escalate immediately.  However, we see tapering by the Fed as a matter of time.  In turn, we see the sharp weakening in the EM assets and currencies in May and thus far in June as, at a minimum, ‘tremors’ prior to a prospective bigger earthquake later this year, when the Fed actually starts tapering.  The key drivers of this bearish view on EM currencies, as we have written on several occasions over the past year and a half, are: i) massive cumulative capital flows having gone to EM in the past eight years; ii) structural weaknesses in EM that have been ignored by investors because of the outsized GDP growth of EM in the years leading to the Global Financial Crisis as well as the extrapolated growth of EM’s population and GDP in the years ahead; iii) a prospective cyclical decoupling between the economies of the US and EM; and iv) the trajectory of the Fed’s policies being out of synch with what EM economies need now. In the 1980s, the LatAm Crisis was in part triggered by Fed tightenings, igniting the large cumulative petrodollar flows that had gone to LatAm. In the 1990s, the appreciation in the dollar contributed to the Asian Currency Crisis. We see similar risks now, arising from a less-easy Fed and a recovery in the dollar. If we are right, the dollar should appreciate against most EM currencies in the coming months, and in some cases appreciate by a significant magnitude.

We have been skeptical of the ‘EM story’ for the past year and a half, and we have written about the various misgivings we have.  At a fundamental level, we believe there has been too much hype about ‘GDP growth’ or population growth and not enough emphasis on some of the very serious structural flaws of EM. Of course, in this discussion about the structural economic flows, it would be unfair to insufficiently differentiate EM countries from each other: South Africa is not South Korea. Equally true, however, is our suspicion that the EM bulls have not exercised sufficient differentiation when they increased investments in EM. Often the weightings of the portfolio allocations were determined by GDP, and worse still, expected GDP, rather than some ‘qualitative’ measures. Some investors have been mesmerized by EM because of extrapolative GDP calculations: projecting economic growth seen in recent years decades into the future, presuming that the current trends would persist. The argument is that it’s hard not to invest in China if China will be the biggest economy in the world in a decade. The Global Financial Crisis further exposed the vulnerabilities of the developed economies, leading some to consider EM as both a ‘high beta’ play on DM as well as a ‘safe haven’ from DM.

We believe many of these popular thoughts may turn out to be wrong, and, as a result, many EM currencies are at risk.

Economic divergence and the Fed. Recent data paint a picture of global economic decoupling, with the U.S. (and Japan) showing signs that it can accelerate in 2H13, while much of the rest of the world will likely decelerate rather than accelerate. Specifically, if the Fed’s relatively optimistic forecasts (the U.S. economy is expected to grow up to 2.8% this year) materialize, the global economy will likely see its first meaningful divergence since the mid-2000s.

Key to this view of ours that the global economy may decouple is the prospective divergence between the economies of Europe and the U.S. The chart below shows the actual GDP paths and the forecasts by the Fed and the ECB.  Not only are we likely to see the growth disparity widen between the U.S. and Europe, but, to the extent that the Fed’s forecasts seem more realistic and the ECB’s outlook rather optimistic, we believe this projected growth gap could persist for a long time.

In turn, from the perspective of an EM economy, if the two largest export markets diverge in growth, the outlook for external demand would not be that great. Further, there are other reasons why EM countries’ own domestic demand may decelerate further (see below).

The global bond and equity markets may or may not have overreacted to Chairman Bernanke’s JEC testimony on May 22, 2013, and, in light of the disappointing U.S. macro data in recent weeks, the Fed may need to postpone the tapering discussion. In any case, we believe it is only a matter of time before the Fed tapers, even if it is difficult to be specific on the timing.

Tapering worse for the rest of the world. Fed tapering will not be good for the rest of the world, mainly because the Fed’s monetary trajectory would be out of synch with the rest of the world and would be in contrast with the monetary trajectories of the ECB, BOJ, and much of EM, many of whose central banks have been cutting interest rates. Indeed, in the weeks since Chairman Bernanke’s testimony on May 22, U.S. equities have outperformed those of the rest of the world, especially the Nikkei, and EM markets measured in USD terms. (Please see the chart below.) This is not surprising to us: the Fed devises policies for the sole benefit of the U.S. Just as it did not show much care about the possible negative side effects of its QE operations, when the time comes for the Fed to start tapering, it will not likely care about the negative side effects for the rest of the world.

Tapering worse still for EM. Furthermore, prospective Fed tapering will likely pose significant risks to EM assets, including bonds, equities, and especially currencies. We believe the underperformance of the EM assets in the last few weeks reflects, effectively, ‘pre-quake tremors’, and that when the Fed actually starts tapering, the shock will likely be quite material.  Here are some thoughts.

— EM economies have already been decelerating and deteriorating. Growth in EM has decelerated quite dramatically in the past years. The slowdown in China is well known and fairly well understood (from 14.2% in 2007 to 7.7% now), as it reflects a structural slowdown that is natural for a country whose per capita income has grown so much so fast. However, we have seen pretty dramatic decelerations in other countries as well. Growth has slowed in Brazil (from 6.1% in 2007 to 1.9% now), in India (from 10.1% in 2007 to 3.0% now), and in Russia (from 9.6% in 2007 to 1.6% now).  Furthermore, despite the deceleration in growth, inflation has remained a problem in Brazil, Turkey, and India, and most of these countries have C/A deficits. This suggests that the economic slowdown in these countries (including China) reflects some potential growth slowdown and not just weak demand.

— The Fed had added an unwelcomed pro-cyclical bias. This is a point we made above, but it very much applies to EM. Back in 2009-11, when many of the EM economies were struggling to digest the large capital inflows, much of which fueled the credit cycles in these economies, they complained about the Fed’s QE operations. Now, the Fed’s intention to taper would pose another complication for the EM economies that are slowing. In other words, the Fed’s policies have been out of synch with the business cycles in EM, and tapering would be just as ‘pro-cyclical’ for EM as the rounds of QE were in the past years.

— ‘Push’ versus ‘pull’. We wrote in ‘Assessing the Sudden Stop Risks for EM’ (May 28, 2013) that the cumulative net private inflows into EM in the past nine years totaled some USD 7.7 trillion. We reiterated a description we had used for a while that the intrinsic nature of these capital flows had deteriorated during this time. Specifically, prior to the Great Recession, much of the capital heading into EM had been ‘pulled’ by the perceived superior economic fundamentals of the EM economies.  However, after the Great Recession, capital flows to EM continued, but they were mostly ‘pushed’, or repelled from DM due to the problems in the latter’s economies and, more importantly, the hyperactive central banks that conducted aggressive QE operations. We came across an IIF paper published earlier this year looking at very similar issues. In particular, it estimated that the expansion in USD liquidity between 2010 and 2012 added around USD 450 billion to the level of annual capital flows to EM and highlighted the risk that a correction in interest rates in global markets might result in a reversal in capital flows, along the lines of ‘push’ and ‘pull’ factors.  If we are right, that EM countries will decelerate further while the Fed starts to taper, then both ‘pull’ and ‘push’ factors will attenuate, undermining the capital flows into EM.

— Official reserves don’t get sold. For the world as a whole, the overall balance of payments should, by definition, be in balance. This means that the current account balance and the net capital flows of DM should just offset those of EM. Net capital flows into EM, therefore, should just be enough to finance the C/A imbalances between DM and EM. Some may point to the massive foreign official reserves of the EM central banks as an ‘insurance’ against sudden stops. We have all seen charts that rank EM countries’ vulnerabilities according to the size of their foreign exchange holdings.  However, we argue that they are not that effective in an actual crisis, mainly because EM central banks don’t tend to sell their reserves nearly aggressively as they buy reserves. In 2008, for example, EM central banks hardly sold their reserves even though their currencies came under severe pressure. The Korean won, for example, weakened by some 50% against the dollar. But the BOK’s reserves declined only modestly. In fact, the BOK sought help from the Fed in the form of swap lines for USD liquidity. There are also political reasons we won’t go into here that make EM central banks reluctant to part with their foreign reserve holdings.

Relative currency vulnerabilities. Which EM countries are more vulnerable to a ‘sudden stop’ in capital inflows? We believe two of the most important variables are i) the country’s current account balance and ii) the cumulative capital inflows. The chart below presents a scatter chart highlighting how various selected EM economies rank, using averages from the last four years.

The countries on the left side of the chart above have run large savings deficit positions in recent years, while those on the right side of the chart are capital-surplus countries. The higher a country appears in this chart, the larger the cumulative foreign capital flows it has received. Thus, in theory, those in the upper-left corner of the chart have i) large CA deficits and ii) have received large foreign capital inflows (e.g., South Africa, India, Turkey) and should be more vulnerable to a ‘sudden stop.’ At the same time, those on the bottom right have capital surpluses and have received relatively little capital inflows (e.g., Russia, China, Korea) and should, therefore, be less vulnerable to a ‘sudden stop.’

Indeed, ZAR, TRY, and INR have all weakened meaningfully in recent weeks, despite the favorable investor opinions of these economies and currencies.

Furthermore, large cumulative capital inflows could pose a risk to a currency, even for countries with modest CA deficits. The Chilean peso, for example, experienced 7% depreciation in the past weeks, despite the country having reasonably good economic fundamentals.

Finally, countries with sizeable CA surpluses should have relatively resilient currencies. CNY and KRW have been reasonably stable. However, RUB and THB still depreciated against the dollar, as their economies slowed and as commodity prices faltered partly because of the deceleration of China.

Bottom line. We continue to believe that most EM currencies will remain vulnerable to further weakness against the dollar, especially if the Fed starts to back out of its current stance, just as EM’s growth decelerates. Many EM countries are overvalued and overrated, we believe. The more the Fed normalizes its stance, the higher the risk of a ‘sudden stop’ in flows to EM. It is difficult to be precise on how imminent this risk is, but as long as the U.S. economy continues to recover, this risk will rise.


Appendix: Past Episodes of ‘Sudden Stops’ Triggered by the Fed

Historically, episodes of sharp reversals in global capital flows were closely linked to changes in U.S. monetary policy or to the appreciation of the USD.

The Latin American crises of the 1980s were the result of an extraordinary accumulation of foreign debt (USD 150 billion in 1978, from USD 29 billion in 1970), following three decades of international expansion of U.S. banks and the development of the Eurodollar market. In the late 1970s, the surge in international oil prices fueled a further rise in capital flows to EM, as energy exporters boosted the supply of USD funds in global financial markets. Loans to EM typically consisted of a syndicated medium- to long-term credit, priced in floating-rate contracts tied to LIBOR. The sharp rise in interest rates in the U.S. (FFR climbed from 5% to 19% between 1976-81) due to surging energy costs and high inflation, coupled with USD appreciation, global growth slowdown, a stagnation of EM exports and very high levels of accumulated debt, resulted in a balance of payments crisis, which ultimately pushed 27 countries to negotiate a restructuring of debt. Capital inflows to Latin American collapsed from around USD 58 billion in 1981 to USD 1.5 billion in 1985.

Similarly, the crises of the early 1990s were also triggered by a shock in USD interest rates. Between 1989 and 1992, the FFR had declined from 9.75% to 3.00% as economic growth in the U.S. and in Europe were depressed. Capital inflows into higher yielding emerging markets rose to unprecedented levels (amounting to almost USD 200 billion in 1993, over 5% of EM GDP). The rapid U.S. economic recovery led the Fed to begin hiking rates in 1994, surprising markets and setting off a reversal in global private capital flows. Mexico, which had received over 7% of GDP worth of inflows in 1993 alone, was one of the hardest-hit EM countries and suffered a currency depreciation of almost 50%.

In the late 1990s, the high growth rates of the Asian economies attracted strong private capital inflows, in an environment of loose monetary conditions in the major industrialized economies, which was reflected in low policy rates in Japan and Europe, and in strong growth in the U.S. financial sector’s total liabilities. The strong appreciation of the USD after 1995 – and its negative effect on the terms of trade of many Asian markets whose currencies were effectively pegged to the dollar – is recognized as one of the key triggers to the reversal in global capital flows in 1998, which culminated in the Asian Financial Crisis.

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.

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