By John Richardson
ALL eyes will be on the precise detail of the statement the US Fed issues after its latest Federal Open Market Committee (FOMC) meeting, which takes place today and tomorrow (March 17-18).
Many analysts think that the ideal outcome for emerging market governments and companies, and those who have gone “long” on the region’s equity markets, is if the word “patient” is retained in the Fed’s comment on its approach to a US interest-rate rise. This would mean no rate rise in the foreseeable future.
Or maybe the Fed will do the next best thing – indicate that a rate rise will not happen in June of this year, the worst case possibility, but will instead be delayed to September 2015 or even later.
If either of the above scenarios plays out, governments and companies in Brazil, Russia, India and China etc. might well sigh with relief. The reason is that the prospect of a later rather than earlier rate rise could drive-down the value of the US dollar and so reduce deflationary pressures.
Companies in emerging markets, which have borrowed heavily in US dollars, might also be relieved – as, of course, the cost of repaying their debts would fall.
And those with long positions in equities should be able to book profits, thanks to a rally in stock markets.
But it is essential that people look beyond all of the above. It is just a distraction – the equivalent of the old cliché of the deckchairs being re-arranged on the deck of the Titanic just before it collided with the iceberg.
The reason is that the Fed’s quantitative easing (QE) policy has done so much damage to emerging markets that repair work is going to take several more years.
Some key facts to consider include the 50% rise in dollar-denominated emerging-market corporate debt since 2009 to $9 trillion, according to the Bank for International Settlements.
The difficulty is that even if the dollar rallies after the FOMC meeting, it is still going to be valued a great deal higher than at the start of 2014 because of the extent of its increases since then (see the above chart, showing the value of the greenback against a basket of other currencies).
Here is another even more important thing to worry about if we end up in a new global economic crisis: The dollar is, of course, the world’s reserve currency, and so, in the event of something similar to 2008 happening again, investors could flock to the greenback as a “safe haven” – thus driving its value even higher. This would make US interest-rate policy almost entirely irrelevant.
A stronger dollar would cause a wave of debt defaults across emerging markets.
Even today, as the New York Times reports, Kaisa, a Chinese property developer, is threatening to pay creditors just 2.4 US cents on the dollar because of its inability to fully service its dollar-denominated borrowings.
“And in Brazil, a wave of bankruptcies among sugar producers has been driven not just by falling sugar prices, but also by debts that they owe in United States dollars,” adds the newspaper.
The fall in Brazilian sugar prices is just one example of what could be the root cause of the new global economic crisis – the deflation that I mentioned above.
Here is how it has worked:
- First the Fed and China over-stimulated the global economy. This inflated commodity prices –and also forecasts for real, sustainable demand growth for commodities. So we have ended with huge investments in new oil, chemicals and other capacities.
- Now that stimulus is being withdrawn, it has become apparent that supply of these commodities is well above actual demand. Hence, we have deflation.
“Not to worry,” you still might think, “OK, it is now obvious that China cannot ‘re-inflate” the world out of this problem. Granted – you were right about that one. But I am sure the Fed, and perhaps a few other central banks, will be able to sort this one out”.
Think again. As Stephen Roach, group chief economist at HSBC, writes:
Taming deflation through monetary policy alone is likely to be a lot more difficult than taming inflation. Interest rates can rise into the stratosphere if necessary. However, they can only fall to zero – or to marginally negative levels – thanks to the existence of cash.
QE easing [globally, not just in the US], meanwhile, may boost asset prices, lower the exchange rate and reduce the risks of immediate financial implosion; but, to date, it has not really succeeded in arresting the march towards a world of falling prices.
With so few policymakers taking the threat of deflation particularly seriously – and with so many of them convinced that economic recovery lies just around the corner – the risk is that we sink further into the deflationary mire thanks to weak monetary growth, high levels of debt and persistent deleveraging.
Should recent deflationary trends continue – all the more likely as central banks take it in turns to play deflationary ‘pass the parcel’ via currency devaluation – policymakers may be faced with an existential crisis every bit as big as they went through in the inflationary 1970s.
But what Roach doesn’t mention is the one word that explains why central bank stimulus was always going to fail: Demographics.