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Another week has passed, and another emerging-markets currency has entered free fall.
This time it’s in Latin America, where the Argentine peso USDARS, -0.8736% sold off to 41.47 against the dollar. I am sure that the International Monetary Fund will come to some sort of rescue, as it has many times in the storied Argentine history, but this situation can be characterized as none other than macroeconomic mismanagement (see chart). So far the most problematic situations in this emerging-market crisis have been the ones identified in “The carnage in emerging markets stocks is just beginning.”
The situations in Turkey and Argentina are similar — both countries have rather explosive external dollar borrowing at a time when U.S. interest rates are rising — but the situation in Argentina may be worse, as the $253.7 billion in external debt is being supported by only $51.3 billion in foreign exchange reserves, while Turkey’s $466.7 billion in total gross external debt — the number is actually over $500 billion if all financing vehicles are added — is covered by $124.3 billion (see chart). Relative to Turkey, Argentina is in a worse situation, given how much it borrowed and how much money it has to support its feeble exchange rate (see chart).
As I have said in past columns, dollar borrowing in this context means dollar shorting as the Argentine and Turkish governments and corporate entities borrow dollars and sell them for their local currencies to use as they please. They then have to buy those dollars back in order to repay the loans as they come due. Rising U.S. interest rates, via fed funds rate hikes and an accelerated Fed balance sheet runoff rate, accelerate loan dollar repayments and cause the exchange value of the dollar to rise. In the case of Argentine pesos and Turkish liras, the value of the dollar is rising rather dramatically as those countries’ net short positions in dollars have risen in the past 10 years, as can be seen in the external debt aggregates.
Dollar Index soars
I have followed this global binge of dollar borrowing with the realization that as the Federal Reserve begins its quantitative tightening cycle, we were going to get precisely this dollar short squeeze, so I was a bit perplexed when the dollar registered its highest exchange rate on the first trading day in 2017 and then pretty much went down all year. In hindsight, it was the unwinding of the eurozone disintegration trades in many local currency and bond markets that caused the fall in the dollar, not the interest rate differentials, which were improving against most members of the U.S. Dollar Index DXY, +0.41%
Currency aficionados may note that the exchange value of the dollar is a lot higher in trade-weighted terms (see chart) than according to the U.S. Dollar Index (see chart), which is not trade-weighted. Instead, the U.S. Dollar Index is rather extremely overweight in euros (57.6%) due to the folding of multiple European currencies into the euro — including former currency powers like the Deutsche mark and French franc.
I am of the opinion that the Broad Trade-Weighted Dollar Index will make an all-time high in this cycle, particularly if President Trump manages to straighten out the trade imbalances with key U.S. trading partners. He does not have to completely eliminate the trade deficit in order for that to happen. All he needs to do is make progress in reducing the trade imbalances, and there is already evidence of some success with key partners like the EU and Mexico.
How high the non-trade-weighted U.S. Dollar Index will go is hard to say, other than to note that it is likely headed a lot higher as political frictions in the eurozone are again intensifying with brexit, Italy and other issues coming to the fore. The eurozone disintegrating is not a zero-probability event and we will get a better feel of what that probability is over the next 12 months.
Biggest unknown: China
While the situations in both Argentina and Turkey have the potential to deteriorate significantly by the end of 2018 via the closure of the capital accounts in one or both countries, the biggest unknown remains China, where we are about to get into tariff retaliation and counter-retaliation after the big packages start being implemented today. The Chinese seemingly have over $3 trillion to defend the yuan, but that does not take into effect the expected losses in the Chinese banking system after their credit cycle ends (see chart).
The Chinese have managed to extend their economic expansion for 25 years due to the policy of lending quotas by controlling the major banks in the country. Every time the economy in China would weaken, the People’s Bank of China (PBOC) would force-feed credit to stabilize the situation. This caused a massive credit bubble where the total leverage ratio in the economy is over 400% of GDP, counting the infamous shadow banking system, which is significantly outside of the control of the Chinese central bank.
I believe that China will have its hard landing soon, which should look similar to the Asian crisis of 20 years ago. Such a hard landing may be accelerated if the Trump trade negotiations do not go well for the Chinese. In the meantime, it does not look like the worst is over for Turkey or Argentina, so it looks like this emerging markets crisis is just getting started.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.
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