Daniel Lacalle

Behold The Sudden Stop. Risk of Emerging Markets Collapse

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The recent collapse of the Argentine Peso and other emerging currencies is more than a warning sign.

It could be the arrival of a “sudden stop”. As I explain in Escape from the Central Bank Trap (BEP, 2017), a sudden stop happens when the extraordinary and excessive flow of cheap US dollars into emerging markets suddenly reverses and funds return to the U.S. looking for safer assets. The central bank “carry trade” of low interest rates and abundant liquidity was used to buy “growth” and “inflation-linked” assets in emerging markets. As the evidence of a global slowdown adds to the rising rates in the U.S. and the Fed’s QT (quantitative tightening), emerging markets lose the tsunami of inflows and face massive outflows, because the bubble period was not used to strengthen those countries’ economies, but to perpetuate their imbalances.

The Argentine Peso, at the close of this article, lost 17% annualized is one of the most devalued currencies in 2018. More than the Lira of Turkey or the Ruble of Russia.

What explains this drop?

For some time now, many of us have warned of the mistake of massively increasing money supply and using high liquidity to avoid much-needed structural reforms. In Argentina, the government of Cristina Fernández de Kirchner left a monetary hole close to 20% of GDP and massive inflation after years of trying to cover structural imbalances with increases in the money supply greater than 30-35% per year.

Unfortunately, as in other emerging markets, the urgent reforms were abandoned, and an alternative formula was tried. Issue great quantities of debt and continue financing a growing public spending with central bank money printing expecting economic growth and cheap debt would offset the growing fiscal and monetary hole.

This wrongly-called “soft adjustment” was justified because of the enormous liquidity in international markets and appetite for emerging markets’ debt driven by consensus estimates of a continued weakening of the US dollar. Many Latin American and emerging market economies fell into the trap. Now, when it stops, and the US dollar recovers some of its weakness, it is devastating.

High fiscal and trade deficits financed by short-term dollar inflows become time bombs.

Argentina even issued a one-hundred-year bond at a spectacularly low rate (8.25%) with a very high demand, more than 3.5 times bid-to-cover. That $ 2.5 billion issuance seemed crazy. A one-hundred-year bond from a nation that has defaulted at least six times in the previous hundred years! Worse of all, those funds were used to finance current expenditure in local currency.

The extraordinary demand for bonds and other assets in Argentina or Turkey was justified by expectations of reforms and a change that, as time passed, simply did not happen. Countries failed to control inflation, deliver lower than expected growth and imbalances soared just as the U.S. started to see some inflation, rates started to rise. Suddenly, the yield spread between the U.S. 10-year bond and emerging markets debt was unattractive, and liquidity dried up faster than the speed of light even with a modest decrease of the Federal Reserve balance sheet. Liquidity disappears because of extremely leveraged bets on one single trade – a weaker dollar, higher global growth- unwind.

However, another problem exacerbates the reaction. An aggressive increase in the monetary base by the Argentine central bank made inflation rise above 23%.

With an increase in the monetary base of 28% per year, and seeking to finance excess spending by printing money and raising debt to “buy time”, the seeds of the disaster were planted. Excess liquidity and the US dollar weakness stopped. Local currencies and external funding face risk of collapse.

The Sudden Stop. When most of the emerging economies entered into twin deficits -trade and fiscal deficits- and consensus praised “synchronized growth”, they were sealing their destiny: When the US dollar regains some strength, US rates rise due to an increase in inflation, the flow of cheap money to emerging markets is reversed. Synchronized indebted growth created the risk of synchronized collapse.

The worrying thing about Argentina and many other economies is that they should have learned from this after decades of similar episodes. But investment bankers and policymakers always say “this time is different”. It was not.

Now Argentina has pushed interest rates to 40% to stop the bleeding. With rampant inflation and economic growth concerns, the Peso bounce is likely to be short-lived.

Massive money supply growth does not buy time or disguise structural problems. It simply destroys the purchasing power of the currency and reduces the country’s ability to attract investment and grow.

This is a warning, and administrations should take this episode as a serious signal before the scare turns into a widespread emerging market crisis.

Structural imbalances are not mitigated by carrying out the same monetary policies that led countries to crisis and discredit.

Over the next three years, the International Monetary Fund estimates that flows to emerging economies will fall by up to $60 billion per annum, equivalent to 25% of the flows received between 2010 and 2017.

This warning has started with the weakest currencies, those were monetary imbalances were largest. But others should not feel relieved. This warning should not be used to delay the inevitable reforms, but to accelerate them. Unfortunately, it looks like policymakers will prefer to blame any external factor except their disastrous monetary and fiscal policies.

Daniel Lacalle is a PhD in Economics and author of “Life In The Financial Markets”, “The Energy World Is Flat” (Wiley) and “Escape from the Central Bank Trap” (BEP).

Chart courtesy Bloomberg


 

25 Responses to Behold The Sudden Stop. Risk of Emerging Markets Collapse

  1. Leeroy 7 May, 2018 at 9:29 am

    Great article. Any idea how bad it will get for South Africa?

    Reply
    • Daniel Lacalle 7 May, 2018 at 11:49 am

      South Africa’s monetary policy is a relevant problem, and the current government’s view of fiscal and monetary imbalances very concerning. Thanks a lot for the comment.

      Reply
  2. Davebee 7 May, 2018 at 5:35 pm

    Well Daniel and Leeroy South Africa look pretty good to me, I just checked on the closing level of the Johannesburg Stock Market for today 7-5-2018 and it’s up in the green a healthy 40% and has been shooting the lights out for the past several days in fact. No USD worries here that’s for sure.

    Reply
    • Daniel Lacalle 8 May, 2018 at 9:47 am

      Great. Let us see

      Reply
    • Ram 8 May, 2018 at 10:37 am

      Almost ALL stock markets are at their synchronised all-time peaks. At current levels of global economic growth, given the debt load everywhere, this is a very dangerous situation and perhaps SA is merely waiting for its “Sudden Stop” event?!

      Under these circumstances, when all looks hunky dory, one should worry the most!

      Reply
  3. agathon 7 May, 2018 at 6:47 pm

    Rome lived upon its principal until ruin stared it in the face.
    Industry is the only true source of wealth, and there was no industry in Rome.
    By day the Ostia road was crowded with carts and muleteers, carrying to the great city the silks and spices of the East, the marble of Asia Minor, the timber of the Atlas, the grain of Africa and Egypt; and the carts brought out nothing but loads of dung. That was their return cargo.
    — The Martyrdom of Man by Winwood Reade (1871)

    Reply
    • Daniel Lacalle 8 May, 2018 at 9:45 am

      The U.S. has technology and industry not only to lead the world, but enough to be almost self sustained.

      Reply
  4. Rohit Srivastava 7 May, 2018 at 6:57 pm

    Do you think India too faces the same imbalances? The currency has been falling relentlessly recently and there is silence in policy.

    Reply
  5. Imran ahmed 8 May, 2018 at 4:42 am

    Great article shared to me by my mentor. Is this impact India too in near future? If so, when will happen sir. Any idea?

    Reply
    • Daniel Lacalle 8 May, 2018 at 9:43 am

      Not as negative, but India still faces twin deficits and large imbalances

      Reply
  6. pankaj ganeriwal 8 May, 2018 at 5:20 am

    What is your view of the Indian currency INR

    Reply
    • Daniel Lacalle 8 May, 2018 at 9:43 am

      India’s currency is the 5th worst this year and faces similar challenges, although not as aggressive as Argentina or Turkey. Hard to see a rebound vs the USD but not expecting a collapse

      Reply
  7. sambhav jain 8 May, 2018 at 7:27 am

    Very informative article sir with deep insight. Can you explain the repercussions for the Indian economy.

    Reply
    • Daniel Lacalle 8 May, 2018 at 9:42 am

      India is also suffering from a twin deficit and the government has relied heavily on borrowing, it needs to rebalance its economy and become less US dollar dependent.

      Reply
  8. Brahmananda Pan 8 May, 2018 at 8:48 am

    Its a good article to read. Thanks. Does it equally applicable for emerging economy like India?

    Reply
    • Daniel Lacalle 8 May, 2018 at 9:41 am

      Yes, India’s currency is the 5th worst this year and faces similar challenges, although not as aggressive as Argentina or Turkey

      Reply
  9. Peter Underwood 8 May, 2018 at 10:21 am

    Many thanks for a welll argued article and I entirely agree the logic. A massisve GFC2 is baked in and there’s nothing that can be done to avoid to inevitable meltdown/globalreset.

    I believe that a crisis event is due in the near term – some 2-3 years max. I have written a book (100,000 words) and have an e-copy available, trying to explain the why and how of our dysfunctional global financial system to ordinary people. I have yet to get a publisher interested although I have emailed 100s of literary agents. The feedback generally advises that the subject is too controversial for them to publish.

    I am offering my book (PDF) free on request to those who are interested: peter@underco.co.uk

    The assumption that the USA and world in general have been expanding for the last 10 years is based on the false premise of GDP. Since real inflation rates (taking commodity and assets together) far exceed nominal growth rates per GDP formula, we have in fact suffered negative growth or a prolonged hidden global depression for 10 years. We have actually seen the end of growth as we have known it and evidence is everywhere to be found, not least of which is energy resource or EROEI.

    My book explains all this and much more.
    Just thought you should know that we are all being fooled by fudged statistics and QE/ZIRP.

    I wonder Daniel, what your views would be on the false computations of GDP – an article would be interesting to read. Best regards, Peter Underwood

    Reply
    • Daniel Lacalle 8 May, 2018 at 10:50 am

      Hi Peter,

      I do not think that GDP is falsely calculated, I just think that GDP is a very partial and incomplete measure of growth, that is why economists use others as well. Thanks

      Reply
      • Peter Underwod 22 May, 2018 at 12:52 pm

        Thanks Daniel, I will note this in my book as a more refined criticism of GDP.
        Thank you for your help.

        PS
        I only just got to your reply as your comments system doesn’t include email notifications of relplies like WordPress or Disqus

        Reply
  10. Ram 8 May, 2018 at 10:32 am

    What about India? Large and Complex economy with a large amount of foreign investments and speculative inflows having driven the economy for the last decade, will it be hit when there is significant dollar outflow?

    Reply
  11. Ram 8 May, 2018 at 10:33 am

    Oops. Sorry. Just saw the other questions on India. Please ignore previous question.

    Reply
  12. DG 14 May, 2018 at 8:31 pm

    Hi,

    Could you please explain what do you mean by “monetary hole close to 20% of GDP”?

    Unfortunately, I don’t understand this term.

    Thank you in advance.

    Reply
    • Daniel Lacalle 17 May, 2018 at 6:21 pm

      The imbalance created in the economy through massive money printing.

      Reply
  13. Luis Riesco 16 May, 2018 at 10:42 pm

    Buen trabajo Daniel

    Reply

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