One fascinating populist meme about how specific emerging markets may survive the recent tantrums has been to cite foreign exchange reserves as talisman or amulet to a crisis.
As reminder any balance of payment disorders are symptoms and not the source of crisis. The common denominator of every crisis is DEBT.
Central Bank Dilemma: To Use Foreign Currency Reserves or Not?
There have been two contrasting approaches adapted by EM central bankers to the current EM tantrums.
Instead of using forex reserves, Turkey’s government has opted to use the interest rate channel to deal with the current disturbance.
Turkey with a record of forex reserves at $ 149.7 billion, almost 2x the Philippines at $ 84 billion, surprised her financial market by massively raising key interest rates across the board to combat the sinking lira. The one week repo rate was increased by a stunning 550 basis points or from 4.5% to 10%! Read my lips FIVE HUNDRED FIFTY basis points. The lira had a one day celebration. Unfortunately the FED reduced monetary accommodation anew that wiped out the one day gains and even led the lira to set new record lows! The market seems to be saying that the current interest rate levels despite the increases have not been sufficient to compensate for the risks. This means more interest rates hikes or the Turkish government will have to begin using her record forex reserves.
Turkey is in dire straits as I discuss here[1]. Not only have the financial system been burdened by huge pile up of debt, they have about $ 160 billion of short term debt due this year. So a sustained lira depreciation and rising rates in Turkey’s creditor nations will mean a double black eye for deeply indebted transcontinental country.
Worst, foreign banks have $ 350 billion of credit exposure on Turkey’s financial system. How much of Turkey’s economy can absorb such tremendous spike in interest rate or a crashing lira before the economy tailspins? Should there be a credit event in Turkey how much of these $350 billion in debt held by foreign banks will be defaulted upon? What will be the repercussions? Are sinking stocks in Europe and the US signs of these? You think that Turkey’s conditions are merely signs of a “hiccup”?
The second approach has been to use forex reserves to fight off a crashing currency. This has been the case with Argentina whose currency has been collapsing whether seen from official rates or black market rates (left window).
The Argentinean government has been draining her forex reserves which have been down by a third now to US $29 billion[2]. This has forced the government to devalue to 8 pesos from 6 pesos last week, even when the black market has long been devaluing. Argentina’s government also raised interest rates by six percentage points[3].
The reason for the draining of reserves? Because the socialist government which nationalized many major industries have come short of securing financing. The Argentine government has massively increased spending by running down the reserves (right window). Argentina remains highly indebted and has still unresolved debt restructuring issues which has been a legacy from her default in 2002[4].
Argentina’s economic data can’t be relied on as the government has threatened domestic economic industry of jail time if they published data which goes against the declaration of the government[5]. What has been evident is that the government’s spending spree and the shrinking access to the pool of global credit markets have been instrumental in inciting a currency crash.
You think Argentina’s dilemma poses as a knee jerk reaction?
Foreign Currency Reserves are Manifestations of Bubbles
I find it ludicrous for the mainstream to keep yelling “forex reserves!”, “forex reserves!”, “forex reserves!” as if forex reserves function as some quaint magical amulet against evil spirits.
But this is reality. The source of problems has not been due to a war with some bad spirits but rather excessive debts looking for a release valve in the face of rising interest rates.
Think of it, the world has $11.434 trillion of foreign currency reserves mostly in US dollars as of the 3rd quarter of 2013, according to the COFER data from the IMF.
If “forex reserves!” equals the magical talisman then we would NOT be experiencing any of these volatilities at all. But this market revulsion has been HAPPENING. It’s been happening IN SPITE of the RECORD international reserve assets. And it has been happening REAL TIME!
The problem is that foreign currency reserves serve as real time manifestations of accrued imbalances rather than the cure to the problem. I can discuss that this as related to the Triffin Dilemma as I did before[6], but this will unduly extend this already prolonged discussion.
The bottom line is that the US dollar standard which financed the world with the FED’s printing machine has fuelled a business cycle in an international scale.
Americans built their comparative advantage via engineering of mostly tradeable debt instruments that has led to a massive growth in her financial industry known as financialization.
The financial industry with less than 10% weighting in the S&P 500 in 1990 became the biggest industry in 2007 as she exported subprime mortgage papers around the world[7].
Meanwhile the world assembled a global network supply chain to supply the US with goods which ultimately transformed into globalization. And US Financialization helped fulfil demand by the world, who accumulated US dollars via trade expressed in record forex reserves, to recycle savings into US dollar assets. Of course the developed world also learned mimic their version of financialization.
At the end of the day, the US dollar standard has brought about record debt levels not only for mature market economies (right window) but for the entire world—estimated by the ING in 2012 at $223.3 trillion or 313%(!) of the GDP[8]. EM debt has been estimated at $66.3 trillion or 224% (!) of GDP in 2012.
Accompanying record debt has been record financial assets[9] that have been galloping far away from global economic growth (left window).
Even more, the world’s ramping up of US dollar reserves by the printing local currency by domestic central banks has fuelled bubbles on a national scale.
Why forex reserves are manifestations of imbalances? Austrian economist Antony Mueller explains[10]. (bold mine)
The expansion of debt by the issuer of the international reserve medium augments the stock of international reserves and the increase of the reserves works like a growth of the global money supply. Central bank balance sheets show that the circulating domestic money forms a debit item, while foreign reserves are part of the credit side. All other things being equal, an increase in foreign reserves implies money creation. This way, foreign debt accumulation by the issuer of a global reserve currency impacts monetary demand through two channels: in the debtor country by the domestic spending of foreign savings, and in the creditor country by the accumulation of foreign exchange reserves which augment the money supply
Where the release valves from the stockpile of foreign reserves are to be expected? Again Professor Mueller (bold mine)
The country, which emits the international reserve currency, does not face a foreign exchange constraint; thus there will be no immediate limit for this process to go to its extremes. Additionally, an expansion of this kind must not be accompanied by price inflation right away. The prices for tradable goods may stay low for a considerable period of time and instead of a price inflation the bubble emerges in the asset markets. After all it is the transaction in the capital account of the balance of payments -- the buying and selling of debt instruments -- which lies at the heart of the process and it is here where the music plays in terms of the bubble. Bubbles, however, have the nasty habit of imploding because they are build on some unsustainable element. This factor within an international debt cycle concerns debt service payments, and this has consequences for international trade and economic growth
Has it not been that the outflows from EM local currency debt instruments and from domestic currency a reflection of troubles in the capital account of the balance of payments?
Eventually bubble enthusiasts will come to realize, that screaming “forex reserves!” “forex reserves!” “forex reserves!” will not serve as free passes to bubbles.
Russian Ruble: A Domestic Outflow
As a final thought, I recently pointed at the unique case of the ongoing pressure on Russia’s currency, the ruble. Russia would have been seen by the mainstream as having a strong external finance conditions, since she has $510 billion of forex reserves (6x the Philippine reserves), has significant surpluses in both trade balance and current account balance (though the latter has been dwindling).
Yet Russia suffers from both property bubble fuelled by credit inflation and runaway local government debt. Lately one of the 200 largest bank in terms of assets the ‘My Bank’ suspended withdrawals for a week. Why would My Bank suspend withdrawals unless she has been financing some problem? Perhaps signs of a bank run?
And guess who’s been selling the ruble?
Well strange as it seems, it has not been foreign outflows as mainstream paints them to be. Russia continues to post foreign capital inflows from 2012 to 2013 (left window). It has been residents whom have been scampering off Russia at a pace that has been picking up pace (right window). There may be various reasons for this such as safehaven, alternative investments or even possibly signs of recognition of a bursting bubble as discussed here[11].
The point worth repeating is that every conditions are unique and that there are no “line in the sand” or specific thresholds before a revulsion on domestic credit occurs.
This brings us to the periphery to core dynamic. For every crisis the first manifestations will be via steepening and spreading of dislocations in the financial markets. Then this transitions into a liquidity squeeze. And finally liquidity squeezes will hit on the real economy possibly either through a credit event first before an economic recession or vice versa.
For those afflicted by the Aldous Huxley syndrome, keep in mind that in the 2007-8 global crisis, the Phisix fell by more than 50% even when the Philippines had floating exchange rate, record forex exchange reserves and low NPLs. The Philippines even narrowly escaped a statistical recession.
Of course one may argue that today’s problem has been different than in 2008. One might assert that today has been an emerging market problem. Part correct. But there are always two sides to a coin. Applied to current events, while one side of the coin is the emerging markets, the other side is the US-developed economies.
But don’t forget: Both of the two sides share the same coin: the DEBT problem coin. Example, just look at how entwined Turkey’s problem has been with foreign banks. The magic number: $350 billion.
[1] See Turkey’s Central Banks Surprises With Huge Interest Rate Increases January 29, 2014
[2] Bloomberg.com The Price of Argentina's Devaluation January 30, 2014
[3] Bloomberg.com Argentine Bonds Plunge Most in Emerging Markets on Outflows February 1, 2014
[4] Wikipedia.org Argentine debt restructuring
[5] See Argentina Government Threatens Jail Terms for People who Question Inflation Data September 15, 2013
[6] See Will the Triffin Dilemma Haunt the Global Financial Markets? August 12, 2013
[7] Wikipedia.org Subprime mortgage crisis
[8] Wall Street Real Time Economics Blog Number of the Week: Total World Debt Load at 313% of GDP May 11, 2013
[9] Institute of International Finance Economic Recovery and Dependence on Asset Values January 8, 2014
[10] Antony P. Mueller Do Current Account Deficits Matter? Mises.org Journals
[11] See Behind Russia’s Central Bank’s “Unlimited Intervention” January 31, 2013
No comments:
Post a Comment