The emerging market debt debacle begins

Nick Hubble

Politicians and central bankers love to talk down their currency. It’s an age-old policy – part of mercantilism.

A cheaper currency makes your exports more competitive internationally. And your imports more expensive, encouraging the consumption of local goods. Both favour the producer over the consumer, because imports cost more.

For some strange reason, favouring producers over consumers in this way wins you votes. At least at the moment. People care about jobs, even if they make you poorer. Except in Sweden, where the falling currency has become unpopular because the country imports so many consumer goods that have become too expensive.

Arguing about which is more important – production or consumption – is a bit of a chicken and egg problem. The distinction, as far as I’m concerned, is that consumption is the basic human need. Therefore, it is the key. Production merely serves the purpose of allowing you to consume.

If you agree with me, then a strong currency is a good thing. It allows you to buy more with less money and less effort. People used to see it that way. A strong currency was a sign of success. Europe was envious of Germany’s Deutschmark.

One of President Donald Trump’s new key economic policymakers, Larry Kudlow, came out in favour of a strong US dollar too. Unfortunately, that’s a very bad thing for everyone else in the world. More on that in a moment.

In a way, discussing the value of the currency as a policy tool has things backwards. In a free market, the currency would not be a matter of policy, but an adjustment mechanism. It’d constantly rebalance economies by tending towards a level that balances trade.

But nobody lives in a free economy. Instead, we have a bizarre system. A reserve currency in the US dollar, while other nations implement a hodgepodge of mercantilist policies. And in Europe, we have a shared currency, which basically means fixed exchange rates.

The reserve currency, mercantilist policy and fixed exchange rates of the euro create imbalances that don’t tend towards self-correction. Predictable imbalances like the US trade deficit and southern Europe’s slow-motion economic destruction.

The problem with these imbalances is that they can correct in a sharp way that triggers a crisis. And that’s exactly what’s happening now.

The emerging market debt debacle begins

Argentina is the first victim. It approached the International Monetary Fund for a bailout on Tuesday. That’s a move full of political irony given the history of the two. But it can’t be helped. Interest rates in Argentina hit 40% by the time I managed to tell you they’re at 33.25% on Monday. The currency fell over 4% on Tuesday.

Turkey looks to be next, with its currency falling seven days in a row. The Brazilian real is looking wobbly too.

What’s going on? The world’s reserve currency is on a tear. The US dollar index, known as the Dixie because of its ticker code DXY, has surged in recent months.

Countries reliant on a stable dollar are in trouble. Specifically, that’s countries which import commodities (which are priced in US dollars), countries that have borrowed in debt denominated in US dollars at the government and corporate level, and countries reliant on trade in US dollars.

It’s not just exchange rates that are messing with emerging markets. American interest rates are on the rise, effectively raising rates on the entire US dollar market.

Add the prospect of quantitative tightening in the US, with its disappearing supply of US dollars, and you have a triple whammy of monetary tightening on trade.

On Tuesday, Federal Reserve chair Jay Powell said he doesn’t care about the pain being dished out to emerging markets by his currency:

“There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs, […] markets should not be surprised by our actions if the economy evolves in line with expectations.”

The indifference from the manager of the US dollar is what tipped Argentina over the edge. Keep in mind that major financial crises tend to start with Fed chairs feigning indifference to the makings of a crash, and continuing to hike interest rates.

This time will be no exception.

Politicising rescue funds

It’s not just the US government that’s tightening up. In Europe, Germany’s new budget withdraws funds across many areas to drive up the fiscal surplus.

Even funding for the EU is set to fall. But where does this leave the gap between northern and southern Europe? The EU is trying to adjust its spending to target nations that comply with its “values”.

It’s always good fun to see politicians try to implement systems with incentives. In this case, southern Europe will benefit at the expense of eastern Europe because of the growing right-wing populism there. Good luck explaining to Hungarians that they’ll have to be more liberal if they want EU money.

The change will only make things worse, driving eastern nations to compromise with Russia. The EU is falling apart without British money. And the economic consequences are dangerous.

The fuse is lit

Argentina, Turkey and other emerging markets are important, especially when you combine them. Throw in turmoil inside the EU and you have something bigger. But these emerging crises haven’t caught the UK stockmarket’s imagination just yet.

So when will they?

The answer is simple. One market is more exposed than others, more tied up than others, unable to rescue itself, and unable to escape its debt and currency trap.

The only escape is politics: abandon the debt and the rules restraining solutions. In other words, default and leave the euro.

It’d be the biggest default on record.

Already, the stockmarket is falling and interest rates are rising. The national stock index was down 2.4% when political leaders rejected a compromise choice for prime minister a few days ago. Bond yields jumped 10 basis points – a big move when you’re starting at 1.76%.

But what makes the coming crisis most remarkable is the level at which it begins from. The country set to go broke in 2018 recently paid the lowest ever level of interest relative to Germany, the measuring stick, and far less than the US government, the global risk-free rate.

Strange things are happening and the chairman of the Federal Reserve isn’t fixing it. We’re in for a crash.

Until next time,

Nick Hubble
Capital & Conflict

Category: Geopolitics

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