Surging US dollar threatens to engulf a lengthening list of heavily-indebted economies. Photo / Getty Images
Surging US dollar threatens to engulf a lengthening list of heavily-indebted economies. Photo / Getty Images
Opinion
The surging US dollar and spike in global borrowing costs threaten to cut off capital flows to emerging markets and engulf a lengthening list of heavily-indebted economies.
The Institute of International Finance (IIF) warned the twin currency crises in Turkey and Argentina may be just the opening drama of a much broader purge as unprecedented levels of dollar leverage come home to roost.
Robin Brooks, the IIF's chief economist, said the disturbing feature of the latest saga is that a rise in yields on 10-year US Treasuries of just 60 basis points has already caused such havoc.
This is half the rise during the "taper tantrum" of 2013, yet the wild moves in the currency markets in Asia, Latin America, and parts of the Middle East have been comparable.
"This leaves us worried how well the emerging market complex will digest higher global funding costs," he said.
Axel Weber, chairman of UBS, said there are already signs of a systemic squeeze as the US Fed raises interest rates and shrinks its balance sheet (reverse QE).
"We are seeing some stress in the dollar funding markets," he said.
Argentina and Turkey borrowed heavily in US dollars and have been running large current account deficits, a toxic mix in a US tightening cycle.
They were accidents waiting to happen. The concern is that the next tier of vulnerable states will be drawn into the quagmire.
"Indebtedness has grown massively in Asia," Weber said.
Jean Pierre Mustier, chief executive of Unicredit, said global markets are still in denial about the Fed.
"The disruptions from changing monetary policy are not being priced in. I am concerned that this could come back with a storm," he said, speaking at an IIF summit in Brussels.
For now it is Turkey in the spotlight, paying the price for an inflationary bubble and political abuse of the central bank. Tim Ash, from Blue Bay, says the bank's credibility is "shot to pieces".
Demonstrators protest against the government economic measures outside the Central Bank in Buenos Aires, Argentina. Photo / AP
An emergency rate rise of 300 basis points has so far failed to stop the currency rout, leading to whispers of capital controls as the last resort. The lira weakened a further 3 per cent to an all-time low of 4.71 against the US dollar. It has dropped 17 per cent in three weeks.
William de Vijlder, chief economist at BNP Paribas, said emerging markets risk a "perfect storm" as the eurozone slows at the very moment that stimulus from US President Donald Trump's fiscal package feeds into the US economy. This has caused the two sides of the Atlantic to decouple. It has catapulted the dollar higher, draining global liquidity and squeezing developing economies through multiple channels.
De Vijlder said zero rates in the rich countries pushed yield-hungry -investors "up the risk ladder" and into emerging markets. This is going into reverse. As stress builds, funds are mechanically compelled to liquidate some of their riskier assets.
"If forced, they sell a slice of their emerging market basket. That is how contagion spreads," he said.
The problem is the sheer scale of offshore dollar lending, often by European and Asian banks outside US control.
The Bank for International Settlements says this has exploded to US$11.4 trillion ($16.4t) from US$2t in the early 2000s. A further US$13t of "equivalent" dollar loans are hidden in derivatives. This makes the world's financial system acutely sensitive to even small moves in the dollar exchange rate and US funding costs.
Nobel economist Paul Krugman said there is a risk of a "classic self-reinforcing crisis" along the lines of the East Asia drama in 1997 to 1998. The pattern is that currencies fall, causing corporate debt to "blow up", further damaging the economy, leading to further currency falls.
"Something slightly scary this way comes," he tweeted.
The Fed could halt the vicious circle at any moment by easing back from monetary tightening, as it did during the Chinese currency alarm of early 2016. This time it has less flexibility. It has to cope with the inflationary threat from Trump's stimulus. Relief may be a long time coming.
