Tag Archives: currency

The Pain QE Tapering Can Cause: First Emerging Markets, Now Developed Economies

In my most recent post I discussed the effects the Fed’s QE tapering would have on emerging markets, specifically Russia. Tapering has really hurt EMs as yield-seeking investors moved their money from relatively high-risk investments in emerging markets to less volatile assets such as U.S. treasury bonds. It’s also worth noting that lots of the negative EM buzz has been fueled by doubts in the speed of the growth of the largest emerging market– China (more on that a bit later).

As it turns out, though, EMs aren’t the only ones hurting. The suffering has spread to developed nations as well. Many developed nations’ currencies have been hit hard:

Early in the day, the Canadian dollar hit a 4 1/2-year low of 1.1225 Canadian dollars to the U.S. currency, though it later recovered in late New York trading to C$1.1130. The euro slumped to $1.3479 intraday, its lowest since November, while the Norwegian krone traded above 6.3 to the dollar for the first time since 2010, and traded at 6.2793 per U.S. dollar late in New York. The greenback rose more than 1% against the New Zealand dollar to US$0.8086 and was up 0.5% against the Australian dollar at US $0.8756.”

It’s strange to see developed nations, especially countries like Norway and Australia, who have had stable, positive GDP growth (both hovering around 2-3%) in the past decade, experience such a hit. The reason lies in the fact that developed economies like Norway and Australia depend on commodities exports. With investors questioning China’s ability to keep growing at the double-digit rates it has in the past, investors fear that the demand “for Norway’s oil, Australia’s iron ore, and New Zealand’s dairy products” will be weakened.

The euro has seen better times as well, falling to its lowest rate against the dollar since November. And with the ECB planning to highten QE measures, U.S. bonds are looking more and more attractive even to proud European investors.

All this investor doubt is causing capital to flow into safe havens like the U.S. and Japan, but my prediction is that this flow is only a temporary happening. The buzz and speculation the Fed’s announcements create cause investors to become over-paranoid about the riskiness of their investments abroad. I think that after some of the media attention subsides, investors will start to realize that the dollar and other safe haven currencies are overvalued, causing capital to flow back out to emerging markets. It may not be in the amounts that were there originally, but at least some of the damage will be undone.

Emerging Markets: Anticipating the Taper

Emerging markets (EM) have been declining lately due to questions about how they will slow capital outflows. According to the Wall Street Journal, “The declines were fueled by concerns that efforts by emerging-market central banks to tighten monetary policy won’t be enough to protect their economies against an exit of investor money”. The two sources of the capital outflows are less liquidity from the Federal Reserve (Fed) and slowing growth in China. On the one hand, the Fed’s asset purchases have already been reduced to $75 billion per month and the Fed is expected to announce a further reduction in their asset purchases during today’s meeting. On the other hand, the Chinese economy entered 2014 with momentum slowing and facing severe structural challenges. While growth remains stellar when set against China’s global rivals, the slowdown is considerable in comparison with its 2007 peak, when the economy expanded more than 14%.

The situation of EM is that of a traditional balance of payments problem. First, capital flowed into emerging markets as investors searched for higher returns because developed countries were pursuing expansionary monetary policy (i.e. low interest rate policy). The capital inflows allowed interest rates to fall in EM and consumption to rise. Then, if capital inflows do not result in sufficient growth and productivity improvements, growth eventually falls and investors sell (leading to capital outflows). In this case, capital outflows are largely a result of less liquidity from the Fed as well as China’s slowdown. Tapering suggests rates will be rising in the U.S. and thus there will be higher returns in the U.S. relative to EM.

Capital outflows cause a decline in growth, decline in asset prices, and currency depreciation. This problem is a particular challenge for capital importers such as Brazil, India, Indonesia, and Turkey. These EM debtor nations rely on substantial foreign capital for growth. It can be tempting for central banks to lower rates to reinvigorate growth, but if the country is close to full capacity, lower rates could cause inflation. Thus, affected countries must raise rates to defend currencies and prevent inflation from rising too much. For example, Turkey’s central bank increased its key interest rate Tuesday in an effort to support their currency. According to the Wall Street Journal, “Although higher rates are supposed to entice investors to continue investing in emerging-market currencies, analysts said the toll the higher interest rates may take on the economic growth of those nations may be too high”. EM face a tough dilemma between lower rates to stimulate the domestic economy or raising rates to slow capital outflows. Although there are costs associated with both strategies, I think more damage can come from capital outflows as this will also cause interest rates to rise.

Despite the challenge facing EM, I do not think there is a crisis at hand. First, the countries involved have large foreign exchange reserves enabling them to defend their currencies during the exodus of foreign capital. This  prevents a collapse in their exchange rates, reduces risks of inflation as well as a domestic bankruptcy. Second, these countries do not have fixed exchange rate regimes. Defending a pegged currency is difficult especially in light of currency speculation.

Lastly, I think EM could potentially rally today. Part of the sell off in EM is due to anticipation that the Fed will further reduce its asset purchases, however, the Fed could potentially decide to take another route. According to Jim Russell, a senior equity strategist at U.S. Bank Wealth Management, “Any variation from [another $10 billion-per-month reduction in the Fed’s bond purchases] or around the forward-looking cadence of a $10 billion reduction per Fed meeting would represent a little bit of a surprise to the markets”. I think such a surprise described by Mr. Russell would be a lift for EM. However, the effect on U.S. equities might be more mixed. On the one hand, retreating from the taper means more stimulus for the economy. On the other hand, it would accompany an underlying theme that the economy is not healthy. I think it is hard to estimate which way this lose-lose situation will go. In any case, the Fed’s decision will have decisive impacts on EM. I look forward to the Fed’s meeting later today.

Emerging Market Trouble

Last week, markets across the globe were rocked by the sharpest decline in over a year. The S&P 500 dropped 3% on the week. Despite relatively positive signs at home, it appeared that trouble in emerging markets was the source of the sell off. Argentina is one of the more interesting and dangerous stories in this EM sell off.

Last week, Argentina’s central bank devalued the peso from 6.92 dollars per peso to 7.88, a twelve percent decline, according to Bloomberg. The country’s foreign-exchange reserves, which the country uses to support this currency peg, have dropped to dangerous levels, forcing the central banks hand. According to the Economist’s Free Exchange blog, foreign-exchange reserves reached a seven year low of $25 billion at the end of 2013. The decline in foreign reserves is a symptom of several structural problems in Argentina, which are posing a threat to its economic stability and putting it at risk of another crisis, like it faced in the 1990s when the country defaulted. The key problems are:

  1. Leadership. President Cristina Fernández de Kirchner has done little to inspire confidence. Her administration has been criticized with corruption and deliberate falsification of inflation data, according to a 2011 Economist post. More recently, she has been absent for nearly a month over the holiday as her countries foreign-exchange reserves dropped precipitously and bond rates spiked as Bloomberg reports.
  2. Protectionism. Argentina has increasingly become more protectionist. The country has taxed agricultural and commodity exports in an attempt to boost domestic manufacturing. Additionally, they impose limits on imports, which are done through delaying specific import items for long periods of time. All of this has served to close Argentina off from international markets and has hurt consumers domestically, who demand superior quality foreign goods. Most recently, the country has imposed restrictions on online purchases abroad (according to the BBC).
  3. Currency controls. More a consequence of the previous two problems, currency controls showcase the lengths to which Argentina must go to preserve its current economic regime. The country has forbidden its citizens from buying foreign currency. In response, a black market in currency trading has sprung up on the streets, where the market exchange rate is over 12 pesos per dollar – nearly 70% higher than the official exchange rate according to Bloomberg.

The problems in Argentina run deep but they do not stop there. Emerging market countries across the globe are now under scrutiny and have seen also their currencies slide over the last several weeks, as the Economist illustrates in the graph below:

This may indicate a troublesome start for the markets this year if EM contagion spreads and threatens developed markets. The Financial Times Alphaville blog, however, points out a more optimistic view point from Capital Economics, a research firm:

In the past, financial crises have indeed tended to sweep from one EM to another, primarily because they shared many of the same vulnerabilities. The financial crisis that began in Thailand in 1997 swept through the rest of Asia, hit Russia and also caused a wobble in parts of Latin America. Today, the emerging world is a very different place.

Capital Economics goes on to bucket different EM countries into different categories with differing levels of risk. They believe that the risk of contagion between these categories is small. Let us hope that this is the case.

Sacramento Kings and Bitcoin

Earlier today, the Sacramento Kings announced that they will start accepting Bitcoin as a form of currency. Merchandise from the team shop will be able to be purchased with Bitcoin starting today. There are also plans to introduce the Bitcoin payments to online shopping for merchandise as well as in store ticket sales, as early as March 1st. (http://money.cnn.com/2014/01/16/news/companies/nba-bitcoin/index.html)

This is the first major sports team to start accepting bitcoin, which makes it a pretty monumental move. The relationship had come to be just over a week ago when the team reached out to BitPay at the Consumer Electronic Show in Las Vegas.

With Bitcoin now being accepted at a mainstream venue in America it seems natural to ask the effect the digital currency will have on the international currency markets.

Before the question can be answered, I will go into a little background on Bitcoin. It is in essence a blend between a credit card and cash and only exists online. One can make online purchases with it, much like a credit card, but can remain anonymous like a cash exchange. Another unique aspect of Bitcoin is the fact that there are no transfer fees. When you use any other online payment you pay a transfer fee, which in reality is payment for the bookkeeping. When doing wire transfers, a fee is charged up front and when you use a credit or debit card a percent of the purchase is charged to the merchant (retail customers do not see it). Bitcoin gets around this by paying anyone to handle the bookkeeping, or what they call mining. Whenever someone completes a transaction they effectively “mined” bitcoin and have some added to their account. Although there is no direct fee, currency is added to the digital world.

So back to the question of the effect of Bitcoin on the currency exchange. Bitcoin was introduced in 2009 and initially used for illegal purchases of regulated items. Over the first few years the currency was extremely volatile, dropping as much as 60% in a few hours (http://www.economist.com/blogs/freeexchange/2013/04/exchange-rates). However the government has worked to shutdown “Silk Road” the major venue for illegal purchases. Bitcoin is now moving to more legal uses, like sales with the Sacramento Kings. This is definitely a step toward a more stable currency.

But a more stable Bitcoin doesn’t necessary mean it will be widespread. Because no one is directly paid in Bitcoin, it is as if the market is strictly imports and exports. Unless the market is able to start paying out in Bitcoins for real world tasks, I don’t see it becoming widespread.