One of the reasons the rich countries' excessive money creation hasn't ignited
a generalized inflation is that today's global economy is, well, global. When
the Fed dumps trillions of dollars into the US banking system, that liquidity
is free to flow wherever it wants. And in the past few years it has chosen
to visit to Brazil, China, Thailand, and the rest of the developing world.
This tidal wave of hot money bid up asset prices and led emerging market governments
and businesses to borrow a lot more than they would have otherwise. Like the
recipients of subprime mortgages in 2006, they were seduced by easy money and
fooled into placing bets that could only work out if the credit kept flowing
forever.
Then the Fed, spooked by nascent bubbles in equities and real estate, began
to talk about scaling back money printing*. The hot money started flowing back
into the US and out of the developing world. And again just like subprime mortgages,
the most leveraged and/or badly managed emerging markets have begun to implode,
threatening to pull down everyone else. A sampling of recent headlines:
Contagion
Spreads in Emerging Markets as Crises Grow
Investors
Flee Developing World
Erosion
of Argentine Peso Sends a Shudder Through Latin America
The
Entire World is Unraveling Before Our Eyes
Chinese
Debt Debacle Supports Soros' 'Eerie' Portrayal
Venezuela
Enacts "Law of Fair Prices"
Argentina
Returns to Villa Miseria
Indian
Rupee Falls to 2-Month Low; Joins Emerging Market Sell-Off
Turkey's
'Embarrassing' Intervention Fails to Curb Lira Sell-Off
Prudent Bear's Doug Noland as usual gets it exactly right in his most recent Credit
Bubble Bulletin. Here are a few excerpts from a much longer article that
should be read by everyone who wants to understand the causes and implications
of the emerging-market implosion:
Virtually the entire emerging market "complex" has been enveloped in protracted
destabilizing financial and economic Bubbles. In particular, for five years
now unprecedented "developed" world central bank-induced liquidity has spurred
unsound economic and financial booms. The massive investment and "hot money" flows
are illustrated by the multi-trillion growth of EM central bank international
reserve holdings. There have of course been disparate resulting impacts on
EM financial and economic systems. But I believe in all cases this tsunami
of liquidity and speculation has had deleterious consequences, certainly
including fomenting systemic dependencies to foreign-sourced flows. In seemingly
all cases, protracted Bubbles have inflated societal expectations.
For a while, central bank willingness to use reserves to support individual
currencies bolsters market confidence in a country's currency, bonds and
financial system more generally. But at some point a central bank begins
losing the battle to accelerating outflows. A tough decision is made to back
away from market intervention to safeguard increasingly precious reserve
holdings. Immediately, the marketplace must then contend with a faltering
currency, surging yields, unstable financial markets and rapidly waning liquidity
generally. Things unravel quickly.
The issue of EM sovereign and corporate borrowings in dollar (and euro and
yen) denominated debt has speedily become a critical "macro" issue. More
than five years of unprecedented global dollar liquidity excess spurred a
historic boom in dollar-denominated borrowings. The marketplace assumed ongoing
dollar devaluation/EM currency appreciation. There became essentially insatiable
market demand for higher-yielding EM debt, replete with all the distortions
in risk perceptions, market mispricing and associated maladjustment one should
expect from years of unlimited cheap finance. As was the case with U.S. subprime,
it's always the riskiest borrowers that most intensively feast at the trough
of easy "money."
So, too many high-risk borrowers - from vulnerable economies and Credit
systems - accumulated debt denominated in U.S. and other foreign currencies
- for too long. Now, currencies are faltering, "hot money" is exiting, Credit
conditions are tightening and economic conditions are rapidly deteriorating.
It's a problematic confluence that will find scores of borrowers challenged
to service untenable debt loads, especially for borrowings denominated in
appreciating non-domestic currencies. This tightening of finance then becomes
a pressing economic issue, further pressuring EM currencies and financial
systems - the brutal downside of a protracted globalized Credit and speculative
cycle.
In many cases, this was all part of a colossal "global reflation trade." Today,
many EM economies confront the exact opposite: mounting disinflationary forces
for things sold into global markets. Falling prices, especially throughout
the commodities complex, have pressured domestic currencies. This became
a major systemic risk after huge speculative flows arrived in anticipation
of buoyant currencies, attractive securities markets, and enticing business
opportunities. The commodities boom was to fuel general and sustained economic
booms. EM was to finally play catchup to "developed."
Now, Bubbles are faltering right and left - and fearful "money" is heading
for the (closing?) exits. And, as the global pool of speculative finance
reverses course, the scale of economic maladjustment and financial system
impairment begins to come into clearer focus. It's time for the marketplace
to remove the beer goggles.
No less important is the historic - and ongoing - boom in manufacturing
capacity in China and throughout Asia. This has created excess capacity and
increasing pricing pressure for too many manufactured things, a situation
only worsened by Japan's aggressive currency devaluation. This dilemma, with
parallels to the commodity economies, becomes especially problematic because
of the enormous debt buildup over recent years. While this is a serious issue
for the entire region, it has become a major pressing problem in China.
At the same time, data this week provided added confirmation (see "China
Bubble Watch") that China's spectacular apartment Bubble continues to run
out of control. When Chinese officials quickly backed away from Credit tightening
measures this past summer, already overheated housing markets turned even
hotter. Now officials confront a dangerous situation: Acute fragility in
segments of its "shadow" financing of corporate and local government debt
festers concurrently with ongoing "terminal phase" excess throughout housing
finance. China's financial and economic systems have grown dependent upon
massive ongoing Credit expansion, while the quality of new Credit is suspect
at best. It's that fateful "terminal phase" exponential growth in systemic
risk playing out in historic proportions. Global markets have begun to take
notice.
There are critical market issues with no clear answers. For one, how much
speculative "hot money" has and continues to flood into China to play their
elevated yields in a currency that is (at the least) expected to remain pegged
to the U.S. dollar? If there is a significant "hot money" issue, any reversal
of speculative flows would surely speed up this unfolding Credit crisis.
And, of course, any significant tightening of Chinese Credit would reverberate
around the globe, especially for already vulnerable EM economies and financial
systems.
No less important is the historic - and ongoing - boom in manufacturing
capacity in China and throughout Asia. This has created excess capacity and
increasing pricing pressure for too many manufactured things, a situation
only worsened by Japan's aggressive currency devaluation. This dilemma, with
parallels to the commodity economies, becomes especially problematic because
of the enormous debt buildup over recent years. While this is a serious issue
for the entire region, it has become a major pressing problem in China.
The crucial point here is that this crisis is not a case of one or two little
countries screwing up. It's everywhere, from Latin America to Asia to Eastern
Europe. Each country's problems are unique, but virtually all can be traced
back to the destabilizing effects of hot money created by rich countries attempting
to export their debt problems to the rest of the world. ZIRP, QE and all the
rest succeeded for a while in creating the illusion of recovery in the US,
Europe and Japan, but now it's blow-back time. The mess we've made in the subprime
countries will, like rising defaults on liar loans and interest-only mortgages
in 2007, start moving from periphery to core. As Noland notes:
Yet another crisis market issue became more pressing this week. The Japanese
yen gained 2.0% versus the dollar. Yen gains were even more noteworthy against
other currencies. The yen rose 4.2% against the Brazilian real, 3.9% versus
the Chilean peso, 3.5% against the Mexican peso, 3.9% versus the South African
rand, 3.8% against the South Korean won, 3.0% versus the Canadian dollar
and 3.0% versus the Australian dollar.
I have surmised that the so-called "yen carry trade" (borrow/short in yen
and use proceeds to lever in higher-yielding instruments) could be the largest
speculative trade in history. Market trading dynamics this week certainly
did not dissuade. When the yen rises, negative market dynamics rather quickly
gather momentum. From my perspective, all the major speculative trades come
under pressure when the yen strengthens; from EM, to the European "periphery," to
U.S. equities and corporate debt.
It's worth noting that the beloved European "periphery" trade reversed course
this week. The spread between German and both Spain and Italy 10-year sovereign
yields widened 19 bps this week. Even the France to Germany spread widened
6 bps this week to an almost 9-month high (72bps). Stocks were slammed for
5.7% and 3.1% in Spain and Italy, wiping out most what had been strong January
gains.
Even U.S. equities succumbed to global pressures. Notably, the cyclicals
and financials were hit hard. Both have been Wall Street darlings on the
bullish premise of a strengthening U.S. (and global) recovery and waning
Credit and financial risk. Yet both groups this week seemed to recognize
the reality that what is unfolding in China and EM actually matter - and
they're not pro-global growth. With recent extreme bullish sentiment, U.S.
equities would appear particularly vulnerable to a global "risk off" market
dynamic.
To summarize:
Developed world banks have lent hundreds of billions of dollars to emerging
market businesses and governments. If these debts go bad, those already-impaired
banks will be looking at massive, perhaps fatal losses. Meanwhile, trillions
of dollars of derivatives have been written by banks and hedge funds on emerging
market debt and currencies, with money center banks serving as counterparties
on both sides of these contracts. They net out their long and short exposures
to hide the true risk, but let just one major counterparty fail and the scam
will be exposed, as it was in 2008 when AIG's implosion nearly bankrupted Goldman
Sachs and JP Morgan Chase.
Last but not least, individuals and pension funds in the developed world have
invested hundreds of billions of dollars in emerging market stock and bond
funds, which are now looking like huge year-ahead losers. The global balance
sheet, in short, is about to get a lot more fragile.
So, just as pretty much everyone in the sound money community predicted, tapering
will end sooner rather than later when a panicked Fed announces some kind of
bigger and better shock-and-awe debt monetization plan. The European Central
Bank, which actually shrank its balance sheet in 2013, will reverse course
and start monetizing debt on a vast scale. As for Japan, who knows what they
can get away with, since their government debt is, as a percentage of GDP,
already twice that of the US.
The real question is not whether more debt monetization is coming, but whether
it will come soon enough to preserve the asset price bubbles that are right
this minute being punctured by the emerging market implosion. If not, it really
is 2008 all over again.
* "Money printing" in this case refers to currency creation in all its
forms, electronic and physical.
