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2018-09-07Macro `n Cheese

Framing EMEs

There’s an EME-crisis everywhere you turn these days, it seems. In today’s post Roger puts the current woes through the lens of central bank actions.

Financial media, investment bank analysis, blogs, twitter. Everywhere I look these days, it seems as if people are looking for the next recession, the next crisis. If it isn’t the yield curve inverting or trade wars, there is something going on with emerging markets. Or maybe it’s just that my consumption of said media is inherently biased. In today’s short analysis I thought we would take a look at the discussions surrounding some Emerging Market Economies (EMEs), such as Argentina and Turkey. While there are, of course, idiosyncratic traits – weaknesses – influencing which economies have experienced the worst turmoil, I find it too much of a coincidence that the stress has increased as the reduction of the Federal Reserve’s (FED) balance sheet has accelerated. This is what the FED’s balance sheet currently looks like:

 

In the lower pane I have also plotted the US current account and the US budget balance. Heading into this year all the talk was of USD weakness as big budget balance deficits and monetary contraction would make investors shy away from USD assets in general and government debt in particular. An extraordinary drop in the value of the USD was to ensue. What has taken place since is more or less the opposite. Admittedly, we haven’t yet seen the full budget effects on government finances and on US funding needs. But so far, at least, it seems as if foreigners are continuing to net purchase US assets and/or US investors are repatriating investments from abroad.


From a global and historical perspective, and in terms of liquidity injections, FED balance sheet tightening is actually the worst for as long as we have data (early 1990’s). Note, also, the FED is not alone in its efforts to reign in liquidity.

 

For the time being, the FED will continue to tighten, even though we start noticing some internal discussions on when it will be a good time to slow the pace of interest rate tightening (the balance sheet reduction process is more or less on auto pilot, unless the business cycle would take a sudden turn for the worse).


Add to this a general dollar liquidity scarcity as many international corporates and financials have been stocking up on (primarily) USD-denominated debt ever since the financial crisis. Since 2008 BIS-data suggests that EMEs have increased their USD exposure by more than 152% (more than 2tn USD) and the whole world (ex USA) is “short” almost 12tn USD.

 

In the good old days, the effects on EMEs of US monetary tightening was, to some extent, balanced by rising imports and, often, rising oil and commodity prices. However, it has been some time since the commodity price setting status was passed over to China. And, currently, with the Yuan’s strong connection to USD and hampered domestic policy levers, it is hard to see much help even for most commodity producing economies. Furthermore, US import growth is probably being held back by weak real wage and household income growth as well as rising tariffs. The tax cuts, nonetheless seem to boost other parts of domestic demand and also push US interest rates higher, making capital flow stay or even flow back home.

 

Little wonder then that EME stock markets are flirting with bear market territory and that (for now) short term inflation expectations (measured here by 2y break-even inflation rates) are heading south.
The short story: If, as I believe, current EME turbulence is caused by US monetary policy tightening (and Chinese credit restraint), then this is not over.


 

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