Beware EM liquidity imbalances
Tighter dollar liquidity will be bad news for emerging market banks and their lending boom of recent years is about to grind to a halt.
Emerging markets are in the line of fire amid tighter US liquidity, slowing EM growth and China’s sputtering growth engine, while investors fall out of love with statist growth models, more generally.
There is a more fundamental reason for fear: tighter dollar liquidity will roil emerging market currencies, debt-servicing capacity, interest rates and nominal growth.
But the strength of the relationship is contested.
After all, economists still can’t agree on the fundamentals of finance: how money is created in the modern economy. You can thank the complexities of fractional-reserve banking systems for that. It is no surprise, therefore, that if working out how money circulates in a closed economy is the stuff of frenzied debate, few understand how external shocks will manifest themselves within countries and the adjustment process.
There are two widely-accepted rules of thumb. The dollar drives global liquidity, given its role as the international reserve currency. And EM surplus nations have more firepower to fight external capital storms.
Most reckon emerging markets should, therefore, be avoided like the plague for one big reason: the supply of US dollars globally appears to be declining, given a contraction in reserves, the ending of the Fed’s QE policy, and the structural improvement in the US current account.
According to research shop Gavekal Dragonomics, we are about to enter a stage without precedent for this era of floating-exchange rates: the world monetary base in 2015 will shrink in absolute terms for the first time. The implications, if this is the case, are huge.
Put simply, the US dollar will strengthen, tightening EM monetary conditions more than a couple of Fed hikes. Borrowers with high dollar debts and limited dollar cash flows will be in the line of fire. After all, the Bank for International Settlements reckons foreigners’ US dollar debts have risen to $9 trillion, as of March, up from $2 trillion in 2000, in part, driven by emerging market corporates indulging in dollar carry trades.
Gavekal Dragonomics reckons tightening global dollar liquidity will force the Fed to enact emergency swaps with foreign central banks – akin to the 1985 Plaza Accord – in a move that will ignite political tensions.
The latter conclusion probably over-states the risks. Though the pace of accumulation has slowed substantially, it’s too early to conclude that aggregate EM reserves are declining, while the ECB and Bank of Japan continue to oil the monetary wheels.
But the risk is clear: investors need to look beyond current-account balances to assess external vulnerabilities. After all, the crises in Brazil and Russia highlight how gross external liabilities are more important than current-account balances in driving financial fragilities.
Worryingly, government yields in Brazil, Colombia, Peru, South Africa, Turkey, Malaysia and Indonesia have risen amid deteriorating economic conditions. The lack of a flight-to-safety bid among local investors highlights the continued immaturity of EM capital markets, which will exacerbate the vicious cycle of outflows, FX weakness, and higher real rates depressing growth.
All this points to big risks facing EM banks, aside from those in the Gulf, which are typically supported by sovereign balance sheets. Narrow money growth will surely have to fall, given capital outflows, and the challenge central banks face in their bid to inject liquidity to prevent interbank rates from rising but at the expense of further depreciating currencies in the process.
As a result, EM banks will have to hike their lending rates, reduce credit growth, and weather the decline in net interest margins. The bank-lending boom since 2009 is grinding to a halt. NPL provisions in Russia and Brazil, for example, are strikingly low, despite high loan-to-deposit ratios, and deep recessions. And regulations have curbed EM banks’ access to dollar wholesale-funding markets.
Liquidity imbalances, in other words, could be a bigger driver than current-account balances in determining the sovereign- and market-adjustment process.