Russian Roulette and the Monetary Policy Bullet

The mess in Russia — including a falling ruble, de facto currency controls, economic contraction, and bank bailouts — is as much about problems specific to Russia as it is about the slowdown in China, the strong dollar, and monetary policy divergence globally. But this has to be worrying for investors looking at emerging markets.

In truth, the problems for emerging markets started six years ago, during the depths of the financial crisis. The genesis of emerging-market vulnerability was born out of the move to zero interest rates by a host of developed-economy central banks trying to spur growth in their weak economies. The U.S. Federal Reserve led the way with its massive quantitative easing programs to buy up government bonds and mortgage-backed securities that began after Lehman Brothers collapsed in a heap in late 2008. Soon thereafter, most other major central banks followed suit, joining the United States in mimicking Japan — which had already been at the zero bound for years.

When the Fed’s quantitative easing program began, it allowed investors to borrow enormous sums of money with virtually no penalty, but the government’s notion that this would be reinvested in U.S. factories and job-creating programs wasn’t to be. Instead, a huge inflow of “hot money” — short-term global portfolio investment funds that are shifted easily as macroeconomic conditions change — was pumped from the developed economies into emerging markets seeking higher returns. While foreign capital investment is generally desirable, these flows were not. Hot money is fickle and speculative — capital flows that can be withdrawn at the drop of a hat, not long-term money used to service longer-term capital projects. The side effect, of course, was that these investments drove up the value of emerging-market currencies to levels that made exports from some emerging markets much less competitive.

In 2010, then Brazilian Finance Minister Guido Mantega said the global economy was “in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.” Brazil and other emerging markets thus sought ways to end the inflow of hot money by reducing interest rates, instituting capital controls, or reducing interest rates to make their currencies less attractive to speculation. These efforts were successful, but they came at a cost, overheating economies and bubbles.

Fast-forward to 2013 and the world had changed dramatically. Suddenly, the currency wars were going in reverse as Washington talked about tightening monetary policy. Then, after the Chinese Communist Party’s third plenum, late in 2014, Beijing formally withdrew its support for export-led, capital-intensive economic growth in favor of a consumer-driven model to rebalance its economy. The rout in industrial commodities like copper, aluminum, and tin was on; emerging-market economies and capital markets ran aground. The Federal Reserve’s tapering of its latest open-ended, large-scale asset purchase program of quantitative easing made the hot money flow out of emerging markets even worse. And so, an emerging-markets crisis developed in early 2014. By April, the mini-crisis was over. But, the potential for another wave was still apparent. After all, China’s growth was still slowing, and by summer the impact on oil prices began to be felt.

When oil started its bear-market run in June 2014, it was already clear that Russia’s economy, weakened by Western sanctions in the wake of the Crimea annexation and fighting in eastern Ukraine, would be dented. The fundamentals point to oversupply as demand growth slumps. But the pace of the decline in prices has the hallmarks and unpredictability of a panic. It’s anyone’s guess when the decline in prices will end.

As such, the currency crisis in Russia is not wholly unexpected.

However, the most important factor to consider is the degree to which low nominal rates in developed economies have dominated discussion in bond markets and have influenced investment strategies. Low or even negative nominal rates are the single most influential policy in the wake of the financial crisis. Just last month, the Swiss National Bank followed the European Central Bank by announcing it was extending its policy rate into negative territory, effectively taxing banks for holding reserves.

These low-rate policies will have a meaningful impact as this credit cycle turns down — as it is clearly doing with the flow of credit to the oil sector in free-fall. There are two simple reasons for this, one of which affects emerging markets.

First, during this economic cycle, there are no clear signs of overheating anywhere — just the opposite. With rates at zero already, it is likely that we will see the flow of credit wane without any room for interest rate policy to work its magic. Normally, we would see debt-service relief across the risk spectrum as central banks slashed rates. But here, with rates already at zero — or even negative — the full measure of the downturn will come to bear on the riskiest debtors via an increase in credit spreads and the premiums paid for long-term debt. We are seeing this in the junk bond market right now, for example, as interest rates there have spiked. That’s going to create serious problems in both debt capital markets and equity markets in the developed world.

But emerging markets will feel the pain as well, particularly from a strong dollar that is the outgrowth of diverging macro policy. In Europe, Japan, China, and elsewhere, economic weakness means that low interest rates and loose monetary policy will continue. But in the United States, signs of economic strength point to continued policy tightening. The result is a strong dollar. And a strong dollar has been the genesis of multiple financial crises in the last few decades, with emerging markets taking a huge hit almost every time. Take just a few historical examples:

• In the 1970s, soaring oil prices allowed money from OPEC countries to flow into U.S. dollars. Flush with petrodollar cash, American banks increased lending to Latin American governments dramatically. But, then U.S. Fed Chairman Paul Volcker’s high interest-rate policy caused turmoil for these borrowers in the early 1980s as exchange rates collapsed and the Latin American debt crisis was born.

• In December 1994, after the Mexican government devalued the peso to stem a current account deficit and avoid a balance of payments crisis, the currency collapsed. Inflation had spiraled out of control, and hyperinflation was a real risk. Hot money fled. A bailout and monetary and fiscal controls followed, creating a depression as GDP collapsed by 6.2 percent in 1995, taking the domestic banking sector along with it. In the end, it was effectively bought out by U.S. banks.

• More recently, in 1997 and 1998, under then U.S. Treasury Secretary Robert Rubin’s strong dollar policy, we got the Asian crisis, the Russian default, the Brazilian IMF bailout, and Argentina’s default. All of these events were related to the strong dollar.

Dollar-denominated debt is a tempting option for governments and corporate interests alike when emerging economies do not have deep capital markets. But a strong dollar is toxic for these borrowers because their liabilities rise as the dollar rises while their domestic assets do not. The Daily Telegraph’s Ambrose Evans-Pritchard writes that the Bank for International Settlements has warned that the $9 trillion in offshore lending poses a serious threat to the emerging markets as the dollar strengthens. This, in turn, will impact global financial stability due to the growing importance of emerging markets.

Does this have to end badly? No. But is the likelihood of volatility and crisis greater when macro policy divergence leads to strength in the world’s reserve currency? Absolutely. Russia is just the canary in the coal mine. Given the strong dollar and the zero-sum game that the world’s central banks are playing with beggar-thy-neighbor monetary policy, the fingers of instability are growing, and the potential for a crisis with them.

Nelson Almeida / AFP