Thursday, August 22, 2013

IF IT BLEEDS... leads.  That's the old newsroom mantra about what is going to capture the eye of the reading public.  It's a pretty cynical comment on the state of the human condition but one that has proven correct too many times to ignore or refute.  That is not my intention to use what has been going on in the emerging markets over the past few weeks to grab your attention but there sure as heck been a lot of blood spilt and an astonishing realization that as the Yogi-Man put it, "It's deja-vu all over again."

If we turn back the clock and remember what happen c. 1997 it almost appears that we are in a time warp.  Facing the so-called "Tequila Crisis," all governments, but especially those in the emerging markets conducted a flight to safety and loaded up on securities deemed "undoubted" in order to preserve capital.  The same was true in the present day.  In order to curb and cure the depressed world-wide economy, central banks lowered interest rates and maintained the low level for a considerable amount (indeed, some have argued until the present day but that is another story).  Recovery did indeed occur, but even more important that the level of interest rates was the amount of liquidity created by the Federal Reserve.  Economic expansion in the emerging markets was fueled almost entirely by debt financing and the overwhelming choice of currency was the U.S. Dollar.  In the past few years we have witnessed the exact same phenomenon.

There's nothing wrong with this but one must remember that a borrowing in dollars requires repayment in dollars and when the local currency is something else, a borrower has created what is known in the trade as an exchange risk; one has to in the final accounting to a nation's central bank to exchange local currency for dollars.

The success of that operation depends very much upon the rate at which local currency is exchanged for dollars.  If borrowed dollars had been exchanged for local currency at the outset at an exchange rate of 1-1 and because of economic conditions the rate of exchange at the time of repayment is 3-1 the borrower has a problem: in more cases than not the collapse of the exchange rate is usually a result of poor economic performance (for whatever reason) in the emerging nation and an assault on the currency by foreign speculators.  If concerted and determined, everyone has a problem.

Over the past few months this has exactly the case across a broad spectrum of emerging market countries but especially those in Asia and in particular India and Indonesia due in no little way to the decline in the Chinese economy.  To combat speculation in their currencies, local interest rates have to be increased creating added stress on borrowers, dollars are sold to maintain a level exchange rate resulting in a scarcity of dollars which leads to further concern not only as to exchange risk but to credit risk as well and added impact on the cycle.  This is precisely what occurred in 1997.  One almost expects to see a herd of borrowers, bankers and government leap out of the bushes, screaming in glee, "Look, we did it again!!!"

Is the result going to be the same?  Frankly, I am no where as close to things as I was way back then to express an opinion, but I can almost shake my head in wonderment at those who, having learned nothing and done the same stupid things expect the outcome to be different.  However, today there is another little added wrinkle.  Remember that flight to quality?  Over.  Those securities then purchased--and yes my friend they are U.S. Government securities--are being sold to provide liquidity for the support of local currencies.  Remember that net holdings by essentially Japan and China fell over the past few months by $65 billion ( my number is larger than that reported as it takes into account multiple periods).  Would you be surprised that the 10 year closed today above 2.90% on a yield basis? And if someone asked, "If this keeps going on, who's going to buy this stuff in the future except the Fed and at what level, what would be your answer?

Anybody got a tourniquet?

1 comment:

  1. Wait. I thought the conventional wisdom was that there was much less dollar denominated financing by the EM this time around. Is the CW wrong?

    Would make this Jackson Hole panel more interesting:

    9:00 AM: “Cross-Border Capital Flows” presented by Helene Rey, professor, London Business School, Discussant: Terrence Checki, executive vice president, New York Fed