More Monetary Policy Madness

Something extraordinarily uncommon is happening.  Something that hasn’t happened since 1988…back when the U.S. federal debt was just $2.6 trillion.

According to the Institute of International Finance, wealth is not flowing into emerging markets for the first time in 27 years.  It’s flowing out.  In fact, net outflows from emerging markets are projected at $540 billion for 2015.  What’s going on?

In short, investors are pulling money out of emerging-market funds at a faster rate than money is flowing in.  Investors see stormy weather in places like China, Russia, and Brazil and are looking for safer harbors.  But that’s not the half of it.

Technically speaking, emerging market economies are on the fritz.  The MSCI Emerging Market Index is at a six year low.  What’s more, the strengthening U.S. dollar, and conversely weaker emerging market currencies, makes the dollar based debts of emerging market economies more expensive.

Emerging market economies are already overloaded with debt.  Yet stagnating economies with increasing debt burdens makes servicing the debt near impossible.  In turn, a cascade of defaults could be forthcoming.

Another Cheap Credit Boom

Last week the International Monetary Fund highlighted some of the unfavorable incongruences facing emerging market economies.  For example, corporate debt of nonfinancial emerging market firms rose from about $4 trillion to over $18 trillion between 2004 and 2014.  In addition, the corporate debt-to-GDP ratio of emerging market companies increased by 26 percent over the same 10 year stretch.

Of course, the boom which preceded the current bust was a great boon to emerging economies.  The stars aligned and vast populations were pulled up from subsistence levels.  Unfortunately, the boom wasn’t entirely sound.

The stars were not shining as brightly as they appeared.  Something else was responsible for their magnificent glimmer and twinkle.  While the boom may have started out as a real demand driven period of economic growth, somewhere it morphed into a cheap credit induced borrowing binge.  Indeed, you can guess who was at the center of it all…

“Low interest rates in advanced economies such as the United States, Europe, and Japan have encouraged this borrowing,” the IMF concluded.  “The increase in firms’ debt-to-asset ratio, commonly known as leverage, has often included a higher share of foreign-currency liabilities.

“Firms that have borrowed the most stand to endure the sharpest rise in their debt-service costs once interest rates begin to rise in some advanced economies.  Furthermore, local currency depreciations associated with rising policy rates in the advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately.  At the same time, lower commodity prices reduce the natural hedge of firms involved in this business.”

More Monetary Policy Madness

Nothing from the IMFs review should come as a surprise.  The commodity and the great building boom of the last decade were bound to end in tears.  What else could possibly happen when absurdly low interest rates pushed things to absurdly high heights?

Over time China, Brazil, and many other emerging economies have plenty of growth potential.  But first there will be significant fallout to work through.  This could also have ramifications to the economic growth prospects of advanced economies too.

The simple fact is advanced economies and emerging economies are more connected than they’ve ever been.  Moreover, economic growth of emerging economies is deteriorating.  This is already spilling over and infecting U.S. based companies.

Caterpillar recently said it would be laying off up to 10,000 employees between now and 2018 because of weak demand for its heavy earth moving and mining equipment.  Schlumberger, the massive oilfield service company, has had 20,000 layoffs this year.  But it isn’t just U.S. corporations being impacted by the decline of emerging economies…monetary policy’s being impacted too.

The recent FOMC statement cited international developments as a consideration for setting the federal funds rate.  Given the debt crisis emerging economies are facing, and the problems a stronger dollar creates, it seems more and more unlikely the Fed will raise rates this year.  More importantly is the fact that a federal funds rate of practically zero is now being called restrictive.

By the account of any sober, clearheaded observer, the capital misallocations of the boom years must be reckoned and there’s not a thing the Fed can do about it.  Nor should they.  Dictating Fed policy to prop up the waning demand for concrete in China is utter madness.  But that is the direction Fed Chair Yellen is taking us.

Sincerely,

MN Gordon
for Economic Prism

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