Sudden Stop: The Risk of an Emerging Markets Crisis

U.S. Dollar strength has put emerging markets under pressure
By Daniel Lacalle, Chief Economist, Tressis Gestión
May 22, 2018 Last Updated: May 22, 2018

The recent collapse of the Argentine Peso and other emerging currencies is more than a warning sign. It could be the  infamous “sudden stop.”

This phenomenon happens when the flow of cheap U.S. dollars into emerging markets suddenly reverses and the funds return to the United States looking for safer assets. The central bank “carry trade” of low-interest rates and abundant liquidity was used to buy “growth” assets in emerging markets.

As the evidence of a global slowdown mounts and interest rates in the United States rise, emerging markets lose the tsunami of inflows and face massive outflows, because the bubble period was not used to strengthen those countries’ economies, but to perpetuate their imbalances.

Argentina Case Study

The Argentine Peso has lost 31 percent this year against the dollar and is one of the most devalued currencies in 2018.

For some time now, many of us have warned of the mistake of massively increasing money supply and using high liquidity to avoid much-needed structural reforms. In Argentina, the government of Cristina Fernández de Kirchner left a fiscal hole close to 20 percent of GDP and massive inflation after years of trying to cover structural imbalances by increasing the money supply more than 30-35 percent per year.

Unfortunately, as in other emerging markets, the urgent reforms were abandoned, and an alternative formula was tried. Issue great quantities of debt and continue financing a growing public spending with central bank money printing expecting economic growth and cheap debt would offset the growing fiscal hole.

This wrongly-called “soft adjustment” was justified because of the enormous liquidity in international markets and appetite for emerging markets’ debt driven by consensus estimates of a continued weakening of the U.S. dollar. Many Latin American and emerging market economies fell into the trap.

Argentina even issued a one-hundred-year bond at a spectacularly low rate (8.25 percent) with a very high demand, more than 3.5 times bid-to-cover. That $2.5 billion issuance seemed crazy. A one-hundred-year bond from a nation that has defaulted at least six times in the previous hundred years! Worse of all, those funds (borrowed U.S. dollars) were used to finance current expenditure in local currency.

Rising Rates

The extraordinary demand for bonds and other assets in Argentina or Turkey was justified by expectations of reforms and a change that, as time passed, simply did not happen. Countries failed to control inflation, deliver lower than expected growth and imbalances soared just as the United States started to see some inflation, rates started to rise.

Suddenly, the yield spread between the U.S. 10-year bond and emerging markets debt was unattractive, and liquidity dried up faster than the speed of light even with a modest decrease of the Federal Reserve balance sheet. Liquidity disappears because of extremely leveraged bets on one single trade – a weaker dollar, higher global growth- unwind.

However, another problem exacerbates the reaction. An aggressive increase in the monetary base by the Argentine central bank made inflation rise above 23 percent.

With an increase in the monetary base of 28 percent per year, and seeking to finance excess spending by printing money and raising debt to “buy time”, the seeds of the disaster were planted. Excess liquidity and the U.S. dollar weakness stopped. Local currencies and external funding face risk of collapse.

Sudden Stop

The Sudden Stop. When most of the emerging economies entered into twin deficits -trade and fiscal deficits- and the mainstream praised “synchronized growth,” they were sealing their destiny: When the U.S. dollar regains some strength, U.S. rates rise due to an increase in inflation, the flow of cheap money to emerging markets is reversed. Synchronized indebted growth created the risk of synchronized collapse.

The worrying thing about Argentina and many other economies is that they should have learned from this after decades of similar episodes. But investment bankers and policymakers always say “this time is different.” It was not.

Now Argentina has pushed interest rates to 40 percent to stop the bleeding. With rampant inflation and economic growth concerns, the Peso bounce is likely to be short-lived. It is unfortunate, that President Macri’s reform government has to resort to these policies because of the legacy left by the Kirchner administration.

But massive money supply growth does not buy time or disguise structural problems. It simply destroys the purchasing power of the currency and reduces the country’s ability to attract investment and grow.

This is a warning, and administrations should take this episode as a serious signal before the scare turns into a widespread emerging market crisis.

Over the next three years, the International Monetary Fund estimates that flows to emerging economies will fall by up to $60 billion per annum, equivalent to 25 percent of the flows received between 2010 and 2017.

The crack has started to appear with the weakest currencies, those were monetary imbalances were largest. But others should not feel relieved. This warning should not be used to delay the inevitable reforms, but to accelerate them. Unfortunately, it looks like policymakers will prefer to blame any external factor except their disastrous monetary and fiscal policies.

Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.