Short-term Capital, Streaming and Steaming

Emerging economies need to and will likely increase interest rates and tighten capital controls. The G-20 ministerial meeting in Seoul didn't solve any problems. The communique promised that the G-20 countries would not engage in competitive devaluations and limit current account surplus.

But the source of the global currency market instability is the U.S.'s strong preference for using monetary policy to solve economic problems, effective or not, and the dollar is the currency of global trade and for commodity pricing. Political trends in the U.S. are moving in a direction less favorable to the strength of the dollar and, hence, the global currency market instability.

The Republican Party is likely to win control of the House in the November mid-term elections. With the Democrats in control of the Whitehouse and the Republicans, the House, no meaningful policy can be achieved to address the U.S.'s structural problems. The Fed will come under more pressure to stimulate the economy. As long as inflation remains low in the short term, the Fed has the excuse to stimulate more, even though it's really driven to do so under political pressure.
 
The Fed will soon announce a scaling up of QE 2. The market estimates the range to be between US$ 500 to 1,500 billion. The dollar is expected to be highly volatile up to the Fed's announcement. If the announced figure is over US$ 1 trillion, the dollar is likely to depreciate, and vice versa. While the currency volatility may decline somewhat after the announcement, it will return when the Fed signals more stimulus, because the monetary stimulus won't solve the structural problems.
 
Since the crisis began two years ago, the Fed has expanded its balance sheet by US$ 1.7 trillion to US$ 2.6 trillion. It will likely continue to expand until either inflation comes to check its policy freedom or the economy recovers sufficiently. The latter depends on when unemployment begins to decline significantly, which requires the economy to grow significantly above 4 percent. The odds are that inflation, rather than growth, will cause the Fed to change its policy. That is one year away. The world must be prepared for currency volatility before then.
 
The Fed's QE affects the currency market rather than the U.S.'s domestic demand – its intended target. Domestic demand is composed of consumption, investment, and fiscal balance. The U.S. household sector is over-leveraged and is coping with asset deflation. Its net asset declined to US$ 53.5 trillion in the second quarter of 2010 from US$ 64.1 trillion in 2006. And its debt declined to US$ 13.45 trillion in the second quarter from the peak of US$ 13.92 trillion. The wealth reduction is 18 times the debt reduction. It is hard to see how extra liquidity due to QE will prompt the household sector to borrow and spend. It becomes possible if the household sector believes in high inflation and low interest rates for years ahead, which means a lower debt burden in future. Hence, they may borrow more now. But, high inflation expectations will prompt everyone to sell treasuries. The collapse of the treasury market will bring down the economy. Thus, the Fed cannot create high inflation expectations now. QE is unlikely to cause households to leverage up.
 
The U.S.' big corporate sector, i.e., listed companies, has US$ 2 trillion in cash on hand or 6 percent of its total assets, a two-decade high. Lack of liquidity seems to be their last worry. They are using the cash for buying other companies or share buybacks. How they allocate their cash clearly exhibits a low desire for investment. On the other hand, they are showing quite a lot of enthusiasm for investment in emerging economies. There are many reasons to explain their behavior. They point to the structural problems that central governments can help solve. But, they may simply take time to resolve. The Fed's QE doesn't address their concerns.

 
The SME sector needs help. But, the big banks don't lend to them, as is usually the case. The bank bailout further increased the banking sector's concentration, as depositors sought the safety of the big banks that can count on government bailouts. The small banks that traditionally lend to SME's are not healthy enough to increase loans rapidly. The big recession severely dented their capital base for lending expansion.

With the Republicans in charge of the House, further fiscal stimulus is extremely unlikely. As fiscal stimulus has become a dirty word in the election campaigns, the odds are that the House would pressure the executive branch to retrench like Britain rather than allow more fiscal stimulus. Hence, the Fed's QE won't change anything there.
 
The QE could improve domestic demand by creating another bubble. The property market isn't a candidate. With inventories at two years' supply the market can't turn around anytime soon. The bond market is already a bubble. But it doesn't have much wealth effect. The stock market is a possibility. The listed corporate sector is quite healthy, benefiting from prudent balance sheet management and international reach. The valuation is around the historical average. If it appreciates to 50 percent above the average valuation, the household sector will recover its net wealth to the pre-crisis peak. Hence, it may borrow and spend again.

Counting on another bubble, however, is risky. Considering the Fed's culpability in the last bubble and its consequences it would be unconscionable for the Fed to pursue another bubble. The U.S. stock market has roughly moved up by 10 percent since early rumblings of expectation for QE 2. It is about the same as the dollar's decline. The lower dollar boosts the international earnings of the U.S.'s corporate sector.

The market appreciation could be explained entirely by that for now. But, the market could become a bubble in the coming months. Wall Street earnings are declining. It is certainly motivated to play the game. Even if the stock market bubble does occur, it wouldn't cause the household sector to borrow and spend again. The memory from the recent crash is too fresh for the household sector to go back to the bad old habits.
 
While QE doesn't affect the domestic demand significantly, it affects the currency market enormously. When the Fed expresses its intention for more QE, the market makes certain assumptions about what would occur. When the Fed buys treasuries, say US$ 500 billion, bondholders as a whole have the same amount in cash. Where does the money go next? More cash should lead to currency depreciation. Hence, it makes sense to sell dollars and buy foreign currencies. The lower dollar would increase the prices of risk assets like commodities and emerging market stocks. Hence, it makes sense to go into these assets too. Hedge funds would borrow dollars and buy such assets to front run other investors. Before the Fed implements QE 2, these asset prices move first. In theory, when the QE 2 is implemented, other investors would do what the hedge funds have done. The latter can unwind their positions and pay off the debts with profits. In reality, other investors may hang on to cash, and the hedge funds, their risk positions.

 
What's occurring now is similar to what occurred in 1992-97 but on a much larger scale. The Fed kept the monetary policy eased to cope with a banking crisis. As liquidity flowed into emerging economies, their stock markets were caught in a swell. The rising domestic liquidity led to rising property prices. The high stock and property prices led to a lot of fund raising and investment. The economies grew rapidly. We know now that the prosperity was a bubble. The investment boom was due to funds availability, not better future earnings outlook. Inflation, another consequence of the liquidity, boosted corporate earnings in the short term, covering up the consequences of over-investment in the short term. When the liquidity began to recede, the house of cards came apart.
 
In 1995, famous hedge funds battled the Malaysian government to move up the Ringgit. The same people fought the Malaysian government to devalue the Ringgit two years later. What occurred then turned efficient market theory into a joke. Governments and international financial institutions promote market-based exchange rates. The currency market has US$ 4 trillion in turnover per day, over eighty times the sum of international trade andFDI. The end users like multinational companies ultimately determine the exchange rates. Every other participant in the market tries to guess what they will pay and front-run them. The problem is that eighty people are trying to guess what one would pay. These eighty people end up gaming among themselves. The massive currency market movements are due to their games, not fundamentals. The challenge for emerging economies is that the game can be so large to throw them around and may destroy them in the end.

When money flows into an emerging economy's asset market, say government bonds, its currency moves up and the interest rate moves down. The former causes inflation to cool off, justifying lower interest rates for the time being. The lower interest rate justifies higher stock and property prices. Both lead to more investment. Capital inflow makes the fund raisings easier to pull off. Some economies even have trade surpluses during such a situation, as the weak dollar increases commodity prices. Thus, investment doesn't even need foreign money. Rising asset prices lead to more consumption. The whole picture looks quite rosy.

For example, Brazil today is quite similar to Malaysia fifteen years ago. Its exchange rate against the dollar has appreciated from 4 to 1.7 in a decade. Without its government intervention, the currency would have appreciated much more. Brazil still reports a small trade surplus of a bit over US$ 1 billion per month. Its annual trade surplus is less than one week's money printing by the Fed. As Brazil is a major exporter of natural resources, its trade surplus is surely a side effect of the U.S.'s money printing, not due to its competitiveness. Malaysia didn't escape the disaster even though it resisted the capital inflow in 1995. Brazil has to do much more to avoid the same fate. It is possible that now is already too late. To avoid a catastrophe, Brazil must stop capital inflows now and also prepare to stop the money from leaving when the market turns. I doubt that Brazil will do that. 

Russia's trade surplus is ten times Brazil's. But, this is due to large energy exports. Its foreign exchange reserves are at US$ 500 billion, almost twice as high as Brazil's, and serve as a buffer to external shocks. Hence, Russia won't end up like a decade ago, devaluing and defaulting. Nevetheless, when the liquidity goes out, the effects on its property and financial markets will severely damage its economy.
 
China is more resilient to an external shock than either Brazil or Russia. It's not just its forex reserves. China is mainly a manufacturing economy. When the liquidity tide goes out, commodity prices would fall sharply, increasing its competitiveness. But, its banking system is vulnerable such shocks. As the domestic land price is grossly overvalued, possibly three to four times, and the banking assets are mainly backed up with land as collateral, a liquidity shock would cause its land market to collapse, possibly crippling the banking system.

The U.S.'s weak dollar policy has already increased the vulnerabilities in the monetary policies of emerging economies. Another year of even more dollar weakness and hot money inflows may plant the seeds for their total destruction. Considering that memories from the last emerging market crisis are still fresh, emerging economies must act now to contain the situation.

First, emerging economies must stop hot money by any means. Forget about free market dogma. This is literally a life-and-death situation. In three months, the market may start to talk about QE 3 by the Fed. The hot money will likely double or triple from here. Financial markets like to say that government interventions are not effective in the end. This is nonsense. A sovereign country can do whatever it wishes, including throwing people in jail and confiscating foreign investment. The argument against it is that the market would punish you for this in future by denying you funding when you need it. Forget that. Russia gave foreign bondholders a deep haircut a decade ago. They are bending backwards to buy Russian bonds now. Besides, emerging economies don't get money when they need it, like ten years ago, even with high interest rates, and see money flooding in when they don't need it like they do now.
 
Second, emerging economies must increase interest rates decisively to cool inflation and asset bubbles. The latter is suicide. It nearly killed the emerging economies a decade ago. They may not survive the next time. When an economic crisis occurs, it can cause political instability. The interplay between the two could trap an economy for a long, long time. If you have forgotten what it was like a decade ago, look at the US, Britain, Spain, Greece, and Ireland today. Do we need more lessons on how harmful bubbles are?

The international community should give up on influencing the U.S. on what it would do. It will do what it will, driven by its domestic politics, even though its actions seem like madness to others. The U.S. starts to make sense when it first throws the people who caused the last bubble into jail rather than desperately searches for some quick fix.

Emerging economies, save yourselves!

Andy Xie is a board member of Rosetta Stone Advisors Limited