You might think the US trade war is about the US. But it isn’t. It’s about the US’ ability to affect other nations.
The real question is how much clout the global superpower has. Is it enough to get its way in the end?
President Donald Trump argues that a trade war is easy to win. One reason he might be right is currency instability. If the US dollar fluctuates, American borrowers don’t feel much of a change. But many borrowers around the world certainly do. And the casualties are lining up fast.
In order to attract foreign investors, many companies in emerging markets borrow in US dollars. The idea is that investors don’t have to worry about the exchange rate risk of the local currency, so they’re willing to lend at lower interest rates.
Take Argentina’s 100-year bond, for example. The serial defaulter was able to borrow at a rate just higher than 7% in US dollars.
The problem is, the exchange rate risk doesn’t just disappear. If you borrow in US dollars, you have to repay in US dollars.
Argentina’s 100-year bonds are trading at a record low one year after being issued. A crash in the Argentine peso has made it hard to earn the dollars needed to repay the debt. An International Monetary Fund bailout is in the works.
And Argentina is very far from alone. There’s a long list of US dollar debt slaves all over the world.
But why is the dollar surging so fast it’s causing trouble for dollar borrowers?
The governor of India’s central bank eloquently wrote in the Financial Times that, “Emerging markets face a dollar double whammy”.
Urjit Patel focused on the American central bank’s quantitative tightening (QT) and the huge fiscal deficits due under Trump. The demand for US dollars from the US Treasury and Federal Reserve will lead to a shortage of dollars with which emerging markets repay their US dollar-denominated debt. If neither the Treasury or Fed blink, “a crisis in the rest of the dollar bond markets is inevitable.”
That’s an extraordinary thing for a central bank governor to write. But with the Indian rupee at a record low against the dollar, Patel knows better than most how much damage the dollar is doing to borrowers. Investors are fleeing the Indian stock and bond market.
The real posterchild of the emerging market dollar debt crisis is Turkey. The lira is down about 20% and the Turkish stockmarket about the same.
According to the investment firm Jefferies, investors withdrew more than $10 billion from emerging market bonds funds in the nine weeks to 20 June.
Somebody popped the US dollar debt binge bubble.
1997 or 2015?
This sort of crisis isn’t new. The Asian financial crisis of 1997 followed the same playbook.
What makes things so interesting this time around is that we have two new factors. The first is QT. And the second is Trump’s trade war. These are deliberate policy actions. And the second one is deliberately causing trouble for other countries.
Lower American trade deficits mean even less US dollars are being sent around the world. Supply and demand tell you that the US dollar will spike even further.
In trade war target China, US dollar debt is causing its biggest problems. Stocks are down 20% since January and the yuan is down 4% in two weeks.
The question is whether this is an action, a reaction, or the market doing its work.
Option one is a so-called weaponised yuan. Perhaps Chinese authorities devalued the yuan as part of their efforts in the trade war. A 6% drop in three months is much like a 6% tariff on all foreign goods. The fact that the yuan fell 11 days in a row suggests the drop was orchestrated. Usually, the government would fight it.
Option two is the same as option one, but it’s a retaliatory strike against Trump. Adjusting the exchange rate to cancel out Trump’s tariffs makes them look futile. But if China’s response in a tit-for-tat exchange plays out in currency markets, that leaves US dollar debtors in China with a bigger bill to pay. Their pain is the unintended consequence.
Option three is the worry. What if the yuan is falling thanks to market forces – a lack of faith in the yuan?
China’s companies have huge debts to repay. Unfortunately, those debts are denominated in US dollars. Which is a royal pain if you’re earning yuan and the exchange rate falls 4%.
Trump is very active on this front in the trade war game. He recently decided not to impose the threatened restrictions on Chinese investment in the US. Chinese money can still flow into the US, bidding up the dollar even more.
Currency manipulation aside, the Chinese policy response gets even more fascinating. Bloomberg reports that the government is considering banning the issuance of certain dollar bonds by certain companies.
Bloomberg managed to get a hold of a Chinese government backed think tank report which worries about a crash in several markets. Analysts wrote, “We think China is currently very likely to see a financial panic” and, “Preventing its occurrence and spread should be the top priority for our financial and macroeconomic regulators over the next few years.”
The Wall Street Journal pointed out that all of this is familiar:
To investors with a long memory, this may sound uncomfortably familiar. The last big yuan selloff, beginning in mid-2015, was heralded by a historic stock-market collapse, a rash of corporate bond defaults and Chinese monetary easing.
The FTSE lost about a thousand points in the resulting carnage.
Until next time,
Capital & Conflict