They have collectively borrowed $5.7 trillion in US dollars, a currency they cannot print and do not control. This hard-currency debt has tripled in a decade, split between $3.1 trillion in bank loans and $2.6 trillion in bonds. It is comparable in scale and ratio-terms to any of the biggest cross-border lending sprees of the past two centuries.
Much of the debt was taken out at real interest rates of 1pc on the implicit assumption that the Fed would continue to flood the world with liquidity for years to come. The borrowers are "short dollars", in trading parlance. They now face the margin call from Hell as the global monetary hegemon pivots.
The Fed dashed all lingering hopes for leniency on Wednesday. The pledge to keep uber-stimulus for a "considerable time" has gone, and so has the market's security blanket, or the Fed Put as it is called. Such tweaks of language have multiplied potency in a world of zero rates.
Officials from the Bank for International Settlements say privately that developing countries may be just as vulnerable to a dollar shock as they were in the Fed tightening cycle of the late 1990s, which culminated in Russia's default and the East Asia Crisis.
The difference this time is that emerging markets have grown to be half the world economy. Their aggregate debt levels have reached a record 175pc of GDP, up 30 percentage points since 2009. Most have already picked the low-hanging fruit of catch-up growth, and hit structural buffers.
The second assumption was that China would continue to drive a commodity supercycle even after Premier Li Keqiang vowed to overthrow his country's obsolete, 30-year model of industrial hyper-growth, and wean the economy off $26 trillion of credit leverage before it is too late.
These two false assumptions have blown up simultaneously, the effects threatening to feed on each other with wicked force. Russia's Vladimir Putin could hardly have chosen a worse moment to compound his woes by tearing up the international rulebook and seizing chunks of territory from Ukraine, a country that gave up its nuclear weapons after a pledge by Russia in 1994 to uphold its sovereign borders.
Stress is spreading beyond Russia, Nigeria, Venezuela and other petro-states to the rest of the emerging market nexus, as might be expected since this is a story of evaporating dollar liquidity as well as a US shale supply-glut.
Turkey relies on imports for almost all its energy and should be a beneficiary of lower crude prices. Yet the Turkish lira has fallen 12pc since the end of November. The Borsa Istanbul 100 index is down 20pc in dollar terms.
Indonesia had to intervene on Wednesday to defend the rupiah. Brazil's real has fallen to a 10-year low against the dollar, as has the index of emerging market currencies. Sao Paolo's Bovespa index is down 23pc in dollars in three weeks.
The slide can be self-feeding. Funds are forced to sell holdings if investors take fright and ask for their money back, shedding the good with the bad. Pimco’s Emerging Market Corporate Bond Fund bled $237m in November, and the pain is unlikely to stop as clients discover that 24pc of its portfolio is in Russia.
There could be a cascade if - as many predict - the Kremlin is forced to impose capital controls, triggering the automatic ejection of Russia from benchmark indices. One might rail against the injustice of indiscriminate selling. Such are the intertwined destinies of countries that have nothing in common.
The Fed has already slashed its bond purchases to zero, withdrawing $85bn of net stimulus each month. It is clearly itching to raise rates for the first time in seven years. This is the reason why the dollar index (DXY) has jumped 12pc since May, smashing through its 30-year downtrend line, a "seismic change" in the words of HSBC.
The US economy has shaken off its long malaise. It grew 3.9pc in the third quarter, an incipient boom. The latest confidence survey by the University of Michigan said expected wage gains "rose to their highest level since 2008". More spoke of job gains than "any other time in the last half century". Consumers are the most positive in "30 years."
This is powerful stuff. New York Fed chief William Dudley has strongly hinted that rate rises may come faster and harder than markets expect, more like the bond crash cycle of 1994 than the dilatory style of 2004.
Fed vice-chairman Stanley Fischer said the Fed will look through the oil crash. "The lower inflation that we'll get is going to be temporary. I wouldn't worry about that very much. (It is) more likely to increase GDP rather than reduce it," he said.
World finance is rotating on its axis, says Stephen Jen, from SLJ Macro Partners. The stronger the US boom, the worse it will be for those countries on the wrong side of the dollar.
"Emerging market currencies could melt down. There have been way too many cumulative capital flows into these markets in the past decade. Nothing they can do will stop potential outflows, as long as the US economy recovers. Will this trend lead to a 1997-1998-like crisis? I am starting to think that this is extremely probable for 2015," he said.
This time the threat does not come from insolvent states. They have learned the lesson of the late 1990s. Few have dollar debts. But their companies and banks most certainly do, some 70pc of GDP in Russia, for example. This amounts to much the same thing in macro-economic terms.
Private debt morphs into state debt since governments cannot allow key pillars of their economies to collapse. Does anybody believe that the Kremlin can walk away from $50bn of external debt owed by its oil giant Rosneft? Or that the $170bn debt owed by Brazil's Petrobas is a purely private matter? Standard & Poor's says the only reason it has not yet slashed Petrobras to junk is because of implicit state support.
These countries have, of course, built $9 trillion of foreign reserves, often the side-effect of holding down their currencies to gain export share. This certainly provides a buffer. Yet the reserves cannot fruitfully be used in a recessionary crisis because sales of foreign bonds automatically entail monetary tightening.
Russia learned this the hard way in 2008 when it burned through $220bn in six weeks defending the rouble. This caused the money supply to contract at double-digit rates and set off a systemic banking crisis. The financial bail-out ultimately cost the Kremlin $170bn.
In other words, these reserves are a mirage. If you deploy them in such circumstances, you choke your own economy unless you can sterilize the effects. China can do this at any time by slashing its reserve requirement ratio to single digits from a giddy 20pc. This would inject $2 trillion or more into the economy. Others do not have such luxury.
Investors are counting on the European Central Bank to keep the world supplied with largesse as the Fed pulls back. Yet the ECB could not pick up the baton even if it were to launch a blitz of quantitative easing, and there is no conceivable consensus for action on such a commensurate scale.
The world's financial system is on a dollar standard, not a euro standard. Global loans are in dollars. The US Treasury bond is the benchmarks for global credit markets, not the German Bund. Contracts and derivatives are priced off dollar instruments.
Bank of America says the combined monetary stimulus from Europe and Japan can offset only 30pc of the lost stimulus from the US. If you think that the sheer force of the US recovery will lift the whole global economy regardless of fading monetary stimulus, none of this may matter.
My own view is that a world awash with excess capacity cannot withstand a fully-fledged dollar tightening shock. The effects will ricochet back into the US eventually, but that could be a long time hence, and this in a sense is the problem for asset markets.
In the end, the Fed may not be able to raise rates, or at least not by much. By the same token, it is questionable whether China's leaders can easily purge the excesses left from their investment bubble without paying an escalating political price.
Both of the G2 monetary superpowers may have to pull the stimulus lever yet again. First markets must endure a rare few months of chilly discipline.
Original Article
Source: telegraph.co.uk/
Author: Ambrose Evans-Pritchard
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