Emerging Market Crisis
An emerging market crisis is brewing all the stars are aligned, the global economy has peaked, trade war, sanctions, and tariffs have entered the diction, central bank rate hikes are underway and the era of central bank currency creation is being curtailed.
So could the mother of all emerging market crisis now be on the horizon?
Emerging markets have a higher cliff to fall from this time around because the greatest monetary experiment, to pump the system with trillions of dollars of newly created currency, post 2008 financial crisis, not only created asset bubbles, it egged on a surge in emerging market lending.
To get a perspective of the emerging market crisis, the cliff height and potential fall let’s zero in Argentina’s oversubscribed sale in 2017 of sovereign bonds which amounted to $16bn with 100-year maturity yielding 8%.
But Argentina is a serial defaulter?
Argentina, a resource-rich country, has defaulted on its sovereign debt eight times since independence in 1816. In 2001 Argentina was dubbed the world’s largest defaulter when it defaulted on $100bn of bonds.
So has the Fed (unintentionally or maybe intentionally) contributed to this looming emerging market crisis through its currency creating bond purchase program, better known as Quantitative easing QE?
“There has to be some big real money player behind this,” said Alejo Costa, chief strategist at BTG Pactual in Buenos Aires.
Indeed, why would there not be large commercial banks taking up the offer, bearing in mind that all that currency sloshing around in the system has distorted bond yields and the commercial banks (high up the food chain have access to all that virtually free money) which needs to be invested.
When some of the most solvent governments charge investors to lend to them that pushes investors into riskier investments.
So an Argentina bond paying 8% seems like a good deal, after all, if you are a commercial bank then you have access to free money (courtesy of the central bank) and it also comes with a bank bailout if the investment goes bad. In other words, for connected commercial banks, it is a no-risk scenario, higher risk investment payout higher yields and if it all goes pear-shaped commercial bank goes cap in hand to the government for a bailout.
The emerging market crisis is likely to be worse this time because the central bank’s monetary easing policy has distorted risk and created a boom in emerging market lending.
Indeed, the emerging market crisis of 2013 known as “Taper Tantrum” could be a taste of what is to come. Back then the Fed was contemplating a move to monetary normalization which entailed several rate hikes and a winding up of QE. When the market got wind of a Fed’s monetary tightening, emerging market stocks tumbled together with bonds and emerging market currencies. In short, talk of central bank tightening created a min emerging market crisis.
Fast forward to now and the potential for an emerging market crisis has been magnified due to even more central bank liquidity which has artificially inflated demand for risky emerging market bonds. Moreover, a change in monetary policy at the Fed which is currently signaling further monetary tightening in a backdrop of slowing global economic growth can only mean a taper tantrum far worse than that experienced five years ago.
So then it is no surprise that an emerging market crisis is playing out with the strong dollar and rising rates likely to accelerate the rotation out of emerging markets into US dollars and treasuries. To give you some idea of the market gyration already investors have piled $320 billion 2Y Treasury in just four months of 2018 and it could explain why the USD is moving upwards.
So is this emerging market crisis a storm in a teacup or something more serious?
In my economic forecasts for 2018 I wrote,“faster Fed tightening could be another main event forecasts for 2018 and that is likely to have a bigger adverse impact on emerging economies. The Taper Tantrums of 2013 could be another main economic event forecast for 2018.
Faster Fed tightening means that the central bank will withdraw liquidity from the market which could also cause investors to panic sell their positions”. So there we have it, yet another forecast you could have taken to the bank.
Argentina is the poster child of today’s emerging market crisis. Argentina is currently going through a liquidity crunch and needs an IMF loan. The current rout in Argentine assets has been brutal, Argentina’s three recent interest rate increases to halt the peso depreciation might be short term and we could see further falls in the peso.
But the emerging market crisis is not confined to Argentina alone. Venezuela is leading the pack, it is in a full-blown monetary collapse-which is the endgame and that means hunting mob style. So oil-rich Venezuela is in a mad max scenario.
Meanwhile, as the Trump administration launches a new attack on NAFTA and threatens to pull out of the free trade agreement the Mexican peso continues to slide.
So this emerging market crisis which also could morph into a credit crisis in emerging markets. The dollar appreciation which is being spurred on by rate hikes and trade war talks is slashing demand for emerging market corporate and sovereign bonds.
“No matter how good things are going in emerging economies, the advanced economies can always pull the rug out from under them because a bulk of the money in their markets comes from the U.S., Europe, and Japan,” says Arvind Rajan, head of global and macro investing at PGIM Fixed Income, a $709 billion fixed-income asset management firm.
Put another way, an emerging market crisis is triggered when the Fed as it western aligned central bank side kicks (ECB, BoJ, BoE) decide to tighten monetary policy.
But an emerging market crisis is the beginning of a credit squeeze which also sparked the 2008 financial crisis and The Great Recession.