Declining U.S. Dollar Liquidity Coming Home to Roost for Emerging Markets

Emerging Markets’ finance ministers today surely feel the pain of their European counterparts in the early 1970s. Shortly after President Nixon removed all U.S. dollar convertibility to gold, European finance ministers complained of the global inflationary pressures of such a move, driven by Nixon’s “guns and butter” policy and a deteriorating current account deficit. In just a generation, the United States transformed from the world’s largest creditor to the largest debtor country. Nonetheless, the superiority of the U.S. Dollar as the world’s reserve currency was never really challenged. Surely, Charles de Gaulle–who tried to tip our hand by trading France’s dollar reserves for gold in 1963–must have been spinning in his grave.

Responding to his European counterparts, U.S. Treasury Secretary John Connally famously said “The dollar is our currency, but your problem.” All of which is true. Sure, I lived in Texas for 12 years. Many of the buildings at my alma mater, Rice University, were funded by the wealth of the oil barons–including that of Sid Richardson, whose ventures helped Connally become a successful businessman in the 1950s. This is typical Texan culture–John Connally was merely being blunt–this has been the official if unspoken policy of the United States since Alexander Hamilton helped establish the First Bank of the United States in 1791.

The QE policies created by outgoing Fed Chairman Ben Bernanke simply continues this tradition of “America first; the rest of the world second.” Even the misguided Fed policies of the early 1930s was no exception. As all former and future Federal Reserve Chairs recognize, Fed policy must be targeted for the good of the U.S. economy and U.S. labor–not fine-tuned to satisfy the whims of finance ministers of foreign countries.  Making policy for the good of the U.S. economy–and the U.S. economy only–is the only way to ensure the superiority of the U.S. Dollar as the world’s reserve currency.

Seen in this light, the current plight of EM countries (e.g. Turkey, South Africa, Brazil, and Russia) is not really a problem for U.S. policymakers, even though U.S. “hot money inflows” have overly inflated EM currencies and assets in recent years. But make no mistake: U.S. Fed tapering, as well as a shrinking U.S. current account deficit  (an expanding U.S. current account deficit acts as a global liquidity provider, as most of world trade is still denominated in US$), will continue to be a drag on EM countries for much of 2014. The fact that recent rate hikes by Turkey, South Africa, Brazil, and Russia failed to stem fund outflows is highly problematic (in Russia’s case, it is especially troubling as Brent Crude is still over $100 a barrel). Cumulative EM net fund flows since January 2013 turned negative last August (below chart courtesy the Bank of England), and we believe fund outflows from EM countries will accelerate as the Fed continues to taper. Other global liquidity providers that are strong enough to arrest this decline–i.e. China and the U.S. consumer–will simply not come to the aid of EM countries. The only possible candidate is ECB easing, but we do not anticipate the ECB to ease aggressively enough to stem the decline in global liquidity.

Chart 1: 2013 Cumulative Net Fund Flows into EM Countries Turned Negative Earlier Last Summer


More important, the state of EM finances has been declining precipitously over the last several years. Studies from the BIS and the Bank of England show that over the last several years, large foreign inflows into EM countries have enabled EM credit levels to rise sharply. As such, credit-to-GDP gaps in most EM economies have risen to levels not seen since the 1997 Asian Crisis, as shown below. With EM outflows now accelerating–and with the Chinese and other EM economies experiencing dramatic slowdowns–I expect EM assets to underperform for at least the next several months. Furthermore, recent corruption scandals in Turkey are reminding investors that political risks in these countries is still quite high. There may be a buying opportunity in EM equities during Q2 or Q3 2014, but for now, stay away.

Chart 2: Credit-to-GDP Gap in EM Economies – Higher than that During the 1997 Asian Crisis


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