Emerging market liquidity squeeze: it’s the US current account, stupid

Sid Verma
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Did the contraction of the US current account reduce global dollar liquidity, triggering the rout in emerging markets? And would the continued contraction of the US trade balance spark a synchronized collapse in emerging-market deficit nations?

This thought-provoking argument from Gavekal Dragonomics, an emerging-markets (EM) research outfit, is worthy of attention.

For years, markets have become accustomed to the global-imbalances school of thought – excess US dollar liquidity and consumption, fuelled by the irrepressible EM bid for US treasuries – as a driver of the global crisis, but is the reverse also true?

Would a substantial fall in the US current account, and associated US dollar shortage overseas, spark an EM rout? And was this the driver for this year’s rout?

The historical precedents suggest so, as per this sobering chart:

Here’s the argument from Charles Gave of Gavekal Dragonomics:

The US dollar is the world’s reserve currency, which in simple terms means that the US is the only country which can settle a foreign deficit by issuing its own money. As such, any “improvement” in the US current-account balance means that fewer dollars show up outside of the US, while the reverse holds true in the event of a deterioration.

Hence, a worsening US current-account deficit creates more global liquidity, while an “improvement” reduces the amount of liquid funds sloshing around the world. During my career, all international financial crises have occurred against the backdrop of an improving US current-account deficit as evidenced by the first chart.

Gave reckons the improvement in the US current account is principally down to the undervaluation of the US dollar, which has effectively been on a downtrend since 2002: 

It is noteworthy that this is only the third time since the start of the floating exchange rate system in 1971 that the US current-account deficit has improved in the absence of a US recession. The previous cases were 1988-1989 against the backdrop of German reunification and Japan’s bubble, and during the 1997 Asian crisis. There were periods when the rest of the world was booming. This is not the case today, which implies that the improvement is due to an undervalued US dollar.

In fact, the US trade balance – stripping out oil and China – has provided little relief to emerging markets ex-China since the US current account has “improved” by an amount equal to 4% of GDP since 2006.

But all of the improvement has taken place against the rest-of- the-world grouping, while the China and energy cohort has remained more or less constant (energy down, China up).

The chief losers in the post crisis adjustment have been those “weak link” economies – Turkey, India, Indonesia, South Africa and Brazil – which have run significant current-account deficits. The impact of the US current-account adjustment has been to reduce this rest-of-the-world grouping’s output by an amount equal to about 4% of US GDP. To make matters worse, they must fund current-account deficits with US dollars, which they are no longer earning.

Those emerging markets faced a Hobson’s choice: they could try to fill the funding gap by engaging in a fire sale of assets (including foreign-exchange reserves), or reduce their deficits by killing demand (and thus imports) through bruising interest rate hikes. Not surprisingly, most of them took the latter route. As a result, their financial markets and currencies have collapsed.

A basic purchasing-power-parity model appears to confirm the view that most G10 currencies, with the exception of the SEK and JPY, are over-valued relative to the dollar:

Source: Bloomberg

The upshot of Gave’s argument is the EMs ex-China have inevitably run up current-account deficits thanks to weak US demand and now the chickens are coming home to roost. Gave elaborates on the mechanics:

If the US current-account deficit exceeds what private-sector entities within reciprocal economies need for working capital, then part of this flow will move to reserves held by foreign central banks. And these reserves will be deposited back at the Fed to finance US budget deficits. This circle of dependence was described by the French economist Jacques Rueff as the “imperial privilege”.

However, if the amounts generated by the US current account are insufficient to meet overseas nations’ needs, then those economies will, as already outlined, be forced to either borrow dollars (not a long-term solution), flog domestic assets or run down foreign-exchange reserves. Hence, when I see central bank reserves deposited at the Fed falling, I know that we are getting close to a “black swan” event, as dumping these precious “savings” is, for any country, always a desperate last resort.

This is the pattern which started to unfold last July. But in the intervening period a most unusual pattern has unfolded. Central bank reserves held at the Fed (ex-China) have fallen, while the number is rising when China is included.

He adds that the implication is China during the past six months captured the whole pool of global liquidity from the US current account. This view correlates with JPMorgan analysts, who estimate a cumulative capital outflow of $100 billion since last May out of 22 EM economies – ex-China and Middle East.