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US Should Weather Global Financial Cooling

US Should Weather Global Financial Cooling

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Monday, 25 January 2016 12:19 PM Current | Bio | Archive


We are clearly betting that the known unknowns won’t be as calamitous as still widely feared. We’ve discussed most of them since the start of the year.

Let’s examine the Ice Age scenario focusing on emerging economies:
 
(1) Edwards’ story. According to a 1/18 Business Insider article about Edwards’ “Woodstock for Bears,” the big theme of his conference was that, “Global growth is no longer enough to service global debt. Creditors will have to take losses. Translated, this means the banks that lent the most money with the least amount of reserves may go bust.
 
“Worst hit are the emerging-market economies, many of which are dependent on China to stoke demand for the commodities they produce. This plan worked well for many years after the 2008 financial crash, and emerging markets loaded up on debt. But as the world shifts from buying more goods to buying more services, China is shifting its economy away from manufacturing and industry. Commodities prices have plunged as a result, along with the currencies of the countries that invested in them.
 
“This makes it more expensive to pay off debt denominated in dollars. Unlike debt denominated in emerging-market economies’ own currency, they can’t just print more.
 
“It’s not just emerging markets that are in trouble. US companies have also loaded up on debt after central banks around the world lowered interest rates to record lows. How will it play out? In the words of Albert Edwards, ‘It will turn very ugly indeed.’”
 
Another 1/13 article covering Edwards’ views noted that he expects to see a minus 5% federal funds rate, a massive renminbi devaluation, currency wars, trade wars, and a deflationary depression.
 
(2) Tett’s story. Gillian Tett, the widely respected FT reporter, hobnobbed in Davos last week and posted a 1/21 article titled “The tiny shifts that can signal huge changes.” Like Edwards, she sees a potential for lots of trouble among emerging markets that borrowed in dollars:
 
“In recent years emerging markets companies in general--and Chinese groups in particular--have dramatically increased their dollar debts. The Bank for International Settlements calculates this now stands at $4,000bn for emerging markets as a whole, four times higher than in 2008. A quarter of this debt has emanated from China.
 
“Until lately, using dollar-based markets to issue bonds or take loans seemed a smart strategy for Chinese groups. After all, the US Federal Reserve has kept dollar rates at rock-bottom lows and the renminbi has strengthened against the dollar in the past decade. But now the US interest rate cycle has turned and the renminbi has weakened. Moreover, contrary to assurances made in Davos by China’s most senior regulator that Beijing is committed to maintaining a stable currency, most delegates I have spoken to expect the renminbi to fall 10-15 per cent against the dollar in the next year.”
 
Tett warned: “Deep in the bowels of the system all manner of financial flows are switching course, creating unexpected knock-on effects for many asset prices. Capital flight from China is one example. The energy sector is another. While the collapse in the oil price has prompted investors to stage a high-profile flight from the sector, oil-producing countries are furtively selling their holdings of US Treasuries and withdraw money from asset managers because governments need the cash. Meanwhile, the prospect of political fragmentation in Europe is causing many big asset managers to reassess their exposures there, too.”
 
(3) BIS’s story. The Ice Age story about emerging markets with dollar-denominated debt is mostly based on data compiled by the Bank for International Settlements (BIS). The December 2015 BIS Quarterly Review shows these data in Table 1 on page 31.
 
It’s not the easiest data to sort out, and the BIS review admits that there are lots of known unknowns. For example, “banks in China and Russia, according to national sources, rely to a considerable extent on domestic dollar deposits to fund dollar loans at home.” I guess that means they owe it to themselves.
 
Even more encouraging: “[D]ollar bonds outstanding have grown faster than dollar loans since 2009. In part, this reflects the retrenchment of global banks, which suffered losses on their cross-border credits during the Great Financial Crisis of 2008-09 and which have since come under pressure from shareholders and supervisors.” This supports our view that most of the “bad stuff” this time has been financed by the capital markets rather than the banks. We still believe that the former can better absorb losses than the latter, thus reducing the likelihood and magnitude of a global financial contagion.
 
(4) IIF’s story. The 1/20 FT reported that “on Wednesday the Washington-based Institute of International Finance said outflows increased as overseas investors pulled out of emerging markets and Chinese companies scrambled to pay off overseas loans in the final three months of the year amid a weakening renminbi. …
 
“Emerging markets saw an estimated $735bn in net capital outflows last year with all but $59bn of that coming from China. In October the global finance industry group had predicted 2015 would see net outflows from emerging markets of $540bn, the first since 1988.”
 
(5) Dalio’s story. Ray Dalio, the founder and CEO of Bridgewater Associates, said Wednesday during an interview with CNBC in Davos that the dollar will strengthen temporarily as foreign investors rush to buy the currency so that they’ll have enough on hand to pay off their massive dollar-denominated debt. He also said, “I think the China situation with the currency is very important. If there’s significant currency weakness, that will mean more imported deflation [to the U.S.]. And it’ll make things more difficult.”
 
All of these stories certainly explain why the dollar has soared 22% since July 1, 2014. It’s done so recently despite a relatively stable euro and a stronger yen. That’s because EM currencies, especially the yuan, have been very weak.
 
Many of the EM currencies have been weakening since 2014, but there has yet to be an EM debt crisis. That’s one of the many fears that have hit the stock market since the beginning of the year. It hasn’t happened so far. But it could still happen. Would that mark the beginning of the Ice Age? It might for EMs, but we think that the US will weather such a climate change better than any other country.
 
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.

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Many of the EM currencies have been weakening since 2014, but there has yet to be an EM debt crisis.
economy, united states, currencies, emerging markets
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2016-19-25
Monday, 25 January 2016 12:19 PM
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