Given that some two-thirds of Wall Street traders have never experienced a Fed tightening cycle, SocGen’s Albert Edwards is not surprised he gets blank looks when he tries to explain how recent events in commodity and EM markets are in many key ways similar to the 1997 Asian crisis.
SocGen’s Albert Edwards explains…
Investors are right to feel that the recent rout in commodity prices differs from that seen in the second half of last year. Back then there was more of a feeling that the decline in the oil price was just partly a catch-up with the weakness seen in other commodities earlier in the year and partly due to a very sharp rise in the dollar ? most notably against the euro.
Indeed the excellent Gerard Minack in his Downunder Daily points out that ?US$ strength and expanding supply have been headwinds over the past four years. But the recent sharp decline in prices has been noteworthy for its breadth: prices have fallen in all major currencies, and across all major commodity groups (see charts below). This suggests that global growth has slowed.” But why?
One theme that has played out as we expected over the last year has been the rapidly deteriorating balance of payments (BoP) situation of emerging market (EM) countries, as reflected in sharply declining foreign exchange (FX) reserves (the BoP is the sum of the current account balance and private sector capital flows). We like to stress the causal relationship between swings in EM FX reserves and their boom and bust cycle.
The 1997 Asian crisis demonstrated that there is no free lunch for EM in fixing a currency at an undervalued exchange rate.
After a few years of export-led boom, market forces are set in train to destroy that artificial prosperity. Boom turns into bust as the BoP swings from surplus to deficit. Why? When an exchange rate is initially set at an undervalued level, surpluses typically result in both the current account (as exports boom) and capital account (as foreign investors pour into the country attracted by fast growth). The resultant BoP surplus means that EM authorities intervene heavily in the FX markets to hold their currency down. We saw that both in the mid-1990s and before and after the 2008 financial crisis (see charts below).
Heavy foreign exchange intervention to hold an EM currency down creates money and is QE in all but name and underpins boom-like conditions on a pro-cyclical basis. Eventually this boom leads to a relative rise in inflation and a chronically rising real exchange rate even though the nominal rate might be fixed. EM competitiveness is lost and the trade surplus declines or in extremis swings to large deficit. The capital account can also swing to deficit as fixed direct investment flows reverse as EM countries are no longer cost effective locations for plant. Ultimately as the BoP swings to deficit and FX reserves fall, QE goes into reverse, slowing the economy and exacerbating capital flight.
As a virtuous EM cycle turns vicious (like now), commodity prices, EM asset prices and currencies come under heavy downward pressure – at which point it is difficult to discern any longer the chicken from the egg. In my view the egg was definitely laid a few years back as EM real exchange rates rose sharply and the rapid rises of FX reserves began to stall.
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As Goldman noted: The big question is obviously what is driving these flows and how long they are likely to continue. We continue to take the view that a stock adjustment is at work, although it is clear that the turning point is yet to come. We will look at this in one of our next FX Views. In the interim, we think an easier question is what this means for G10 FX. This is because this shift in China’s balance of payments is sure to depress reserve accumulation across EM as a whole, such that reserve recycling – a factor associated with Euro strength in the past – is unlikely to be sizeable for quite some time.
In other words, for once Goldman is speechless, however it is quick to point out that what traditionally has been a major source of reserve reflow, the Chinese current and capital accounts, is no longer there.
It also means that what may have been one of the biggest drivers of DM FX strength in recent years, if only against the pegged Renminbi, is suddenly no longer present.
While the implications of this on the global FX scene are profound, they tie in to what we said last November when explaining the death of the petrodollar. For the most part, the country most and first impacted from this capital outflow will be China, something its stock market has already noticed in recent weeks.
But what is likely the take home message for non-Chinese readers from all of this, is that while there has been latent speculation over the years that China will dump US treasuries voluntarily because it wants to (as punishment or some other reason), suddenly China is forcedto liquidate US Treasury paper even though it does not want to, merely to fund a capital outflow unlike anything it has seen in history. It still has a lot of 10 Year paper, aka FX reserves, left: about $1.3 trillion at last check, however this raises two critical questions: i) what happens to 10 Year rates when whoever has been absorbing China’s Treasury dump no longer bids the paper and ii) how much more paper can China sell before the entire world starts paying attention, besides just JPM and Goldman… and this website of course.
Finally, if China’s selling is only getting started, just what does this mean for future Fed strategy. Because one can easily forget a rate hike if in addition to rising short-term rates, China is about to dump a few hundred billion in paper on a vastly illiquid market.
Or let us paraphrase: how soon until QE 4?
