This week’s Outside the Box continues with a theme that I and my colleague Worth Wray have been hammering on for some time: the very real potential for a rising dollar to trigger the next global financial crisis.
We are concerned about the consequences of multi-speed economic growth around the world and the growing divergence between major central banks. In our opinion, if these trends persist, they likely mean (1) a major US dollar rally, (2) a rapid unwind of QE-induced capital flows to emerging markets, (3) a hard slide in fragile emerging-market and commodity-exporter currencies, and (4) financial shocks capable of ushering in a new global financial crisis.
Alongside true macro legends like Kyle Bass, Raoul Pal, Luigi Buttiglione, and Raghuram Rajan, Worth and I have written about this theme extensively in 2014 (“Central Banker Throwdown,” “Every Central Bank for Itself,” “The Cost of Code Red,” “Sea Change,” “A Scary Story for Emerging Markets”). Now it’s quickly becoming a mainstream macro theme on almost everyone’s radar. Virtually every economist and investment strategist on Wall Street has a view on the US dollar and the QE-induced carry trade into emerging markets… and anyone who doesn’t should start looking for a different job.
Policy divergence is really the only macro theme that matters right now. And on that note, the Bank for International Settlements just released its predictably must-read quarterly review, with an urgent warning:
The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on EMEs [emerging-market economies]. For example, it may expose financial vulnerabilities as many firms in emerging markets have large US dollar-denominated liabilities. A continued depreciation of the domestic currency against the dollar could reduce the credit worthiness of many firms, potentially inducing a tightening of financial conditions.
@BIS_org: US dollar as global unit of account in debt contracts means a stronger dollar constitutes tightening of global financial conditions.
This is in spite of continued efforts by central banks to ease monetary conditions. Calling attention to that very risk in our Halloween edition of Thoughts from the Frontline, Worth explained that the catalysts are already in position to spark a collapse in a number of fragile emerging markets if the dollar moves even modestly higher (into the low 90s on the DXY Index); but we have struggled to quantify the actual size of the nebulous USD-backed carry trade that could now come unwound at any moment.
Reasonable estimates range from $2 trillion to $5 trillion. The true number could be even larger if more speculative money has slipped through the cracks than has been officially reported in places like China; or it could be smaller if a significant portion of recent inflows represents a more permanent deepening of emerging-market financial systems rather than an attempt to escape financial repression in the developed world. It’s hard to know for sure, and that’s why this week’s Outside the Box is so important.
In a recent presentation at the Brookings Institution, BIS Head of Research and Princeton University Professor Hyun Song Shin shared his research revealing that dollar-denominated credit to non-bank offshore borrowers is now more than $9 TRILLION and at serious risk in the event of continued policy divergence.
I’d encourage you to listen to or download an audio recording of Dr. Shin's presentation, and take some time to flip through his slides; but David Wessel’s cogent summary, which follows in today’s Outside the Box, will give you an idea of what may happen as the US dollar rallies. It’s short, sweet, and REQUIRED READING for anyone who wants to understand where the global financial system is heading in the coming quarters.
Then we wrap up with an essay on the same theme by my friend Mohamed El-Erian, who is typically not as strident in his wording; but for those of us who know Mohamed, this is the equivalent of him pounding the table:
Avoiding the disruptive potential of divergence is not a question of policy design; there is already broad, albeit not universal, agreement among economists about the measures that are needed at the national, regional, and global levels. Rather, it a question of implementation – and getting that right requires significant and sustained political will.
The pressure on policymakers to address the risks of divergence will increase next year. The consequences of inaction will extend well beyond 2015.
For readers interested in this theme, let me also offer a link to some on-the-record remarks from Claudio Borio, the head of the Monetary and Economic Department at the BIS, and Dr. Shin, preceding the release of the BIS quarterly report. For a representative of such a staid and sober organization, Mr. Borio uses a lot of rather disconcerting terms. He is clearly very concerned. Again, you can read the full BIS quarterly review here.
I’ve spent some time this week working with Jack Rivkin and our respective teams at Altegris and Mauldin Economics, putting together the lineup for our 2015 Strategic Investment Conference. I think it will be our best conference ever. You should definitely save the dates April 29 through May 2, as this will be a can’t-miss conference. We will get you more details soon.
I trust your week is going well. We are planning for the holidays and looking forward to some great family time. We’ll see if a new grandchild shows up in time for Christmas or decides to become a New Year’s baby.
Your thinking about 2015 analyst,
John Mauldin, Editor
Outside the Box
How the Rising Dollar Could Trigger the Next Global Financial Crisis
By David Wessel
Wall Street Journal, Dec. 7, 2014
A slide from Hyun Song Shin’s presentation to the Brookings Institution on financial stability risks shows the Bank for International Settlement’s analysis of dollar lending to non-banks outside of the United States.
Bank for International Settlements
Hyun Song Shin, who is on leave from Princeton while chief economist at the Bank for International Settlements in Basel, spends a lot of time wondering what could cause the next financial crisis. He suspects it will be something different from the leveraged bets on housing that were at the root of the last crisis.
So, what might it be? Perhaps the steady rise of the U.S. dollar on global currency markets.
In recent presentations at the Brookings Institution, Mr. Shin documented the growing use of the U.S. dollar by borrowers and lenders outside of this country. U.S. banks and bond investors have lent $2.3 trillion outside the U.S. Foreign banks and foreign bond investors have lent much more: $6.5 trillion.
(Mr. Shin and colleagues at the Bank for International Settlements elaborated on his latest analysis in the bank’s new Quarterly Review posted Sunday.)
When the dollar rises, though, all this runs in reverse, effectively tightening global financial conditions, particularly in emerging markets. The emerging-market currency falls. The manufacturer has trouble making payments on its dollar loans; so do its peers. Banks lend less readily. Capital investment stalls. Global money managers–the ones with lots of short-term wholesale deposits that search the world for the best yields–see a falling local currency and a weakening economy and pull money from the emerging-market banks.
Then, global asset managers who had been lured by a high-growth story see that it is now over and do the same thing, selling emerging-market corporate bonds. That pushes up interest rates that businesses in emerging markets have to pay, and weakens them further in a vicious cycle.
“Even if you have long-term investors and you don’t have [leveraged investors], if events in the financial markets translate into events in the real economy, you can get a feedback loop,” Mr. Shin says. And this, he adds, is a very different mechanism than the insolvency of highly leveraged financial institutions that was at the heart of the recent global financial crisis.
All this is a timely reminder that all the important steps taken to strengthen the foundations of the world’s banks in response to the last crisis aren’t a cause for complacency.
A Year of Divergence
By Mohamed El-Erian
Project Syndicate, Dec. 11, 2014
LAGUNA BEACH – In the coming year, “divergence” will be a major global economic theme, applying to economic trends, policies, and performance. As the year progresses, these divergences will become increasingly difficult to reconcile, leaving policymakers with a choice: overcome the obstacles that have so far impeded effective action, or risk allowing their economies to be destabilized.
The multi-speed global economy will be dominated by four groups of countries. The first, led by the United States, will experience continued improvement in economic performance. Their labor markets will become stronger, with job creation accompanied by wage recovery. The benefits of economic growth will be less unequally distributed than in the past few years, though they will still accrue disproportionately to those who are already better off.
The second group, led by China, will stabilize at lower growth rates than recent historical averages, while continuing to mature structurally. They will gradually reorient their growth models to make them more sustainable – an effort that occasional bouts of global financial-market instability will shake, but not derail. And they will work to deepen their internal markets, improve regulatory frameworks, empower the private sector, and expand the scope of market-based economic management.
The third group, led by Europe, will struggle, as continued economic stagnation fuels social and political disenchantment in some countries and complicates regional policy decisions. Anemic growth, deflationary forces, and pockets of excessive indebtedness will hamper investment, tilting the balance of risk to the downside. In the most challenged economies, unemployment, particularly among young people, will remain alarmingly high and persistent.
The final group comprises the “wild card” countries, whose size and connectivity have important systemic implications. The most notable example is Russia. Faced with a deepening economic recession, a collapsing currency, capital flight, and shortages caused by contracting imports, President Vladimir Putin will need to decide whether to change his approach to Ukraine, re-engage with the West to allow for the lifting of sanctions, and build a more sustainable, diversified economy.
The alternative would be to attempt to divert popular discontent at home by expanding Russia’s intervention in Ukraine. This approach would most likely result in a new round of sanctions and counter-sanctions, tipping Russia into an even deeper recession – and perhaps even triggering political instability or more foreign-policy risk-taking – while exacerbating Europe’s economic malaise.
Brazil is the other notable wild card. President Dilma Rousseff, chastened by her near loss in the recent presidential election, has signaled a willingness to improve macroeconomic management, including by resisting a relapse into statism, the potential benefits of which now pale in comparison to its collateral damage and unintended consequences. If she delivers, Brazil would join Mexico in anchoring a more stable Latin America in 2015, helping the region to overcome the disruptive effects of a Venezuelan economy roiled by lower oil prices.
Of course, there is no theoretical limit on divergence. The problem is that exchange-rate shifts now represent the only mechanism for reconciliation, and the divide between certain market valuations and their fundamentals has become so large that prices are vulnerable to bouts of volatility.
For the US, the combination of a stronger economy and less accommodative monetary policy will put additional upward pressure on the dollar’s exchange rate – which has already appreciated significantly – against both the euro and the yen. With few other countries willing to allow their currencies to strengthen, the dollar’s tendency toward appreciation will remain strong and broad-based, potentially triggering domestic political opposition.
Moreover, as it becomes increasingly difficult for currency markets to perform the role of orderly reconcilers, friction may arise among countries. This could disturb the unusual calm that lately has been comforting equity markets.
Fortunately, there are ways to ensure that 2015’s divergences do not lead to economic and financial disruptions. Indeed, most governments – particularly in Europe, Japan, and the US – have the tools they need to defuse the rising tensions and, in the process, unleash their economies’ productive potential.
Avoiding the disruptive potential of divergence is not a question of policy design; there is already broad, albeit not universal, agreement among economists about the measures that are needed at the national, regional, and global levels. Rather, it a question of implementation – and getting that right requires significant and sustained political will.The pressure on policymakers to address the risks of divergence will increase next year. The consequences of inaction will extend well beyond 2015.