The emerging market story has unfortunately been turned into, as the kids say, a meme. According to Bloomberg, the “weakest” of the EM currencies have been dubbed the “Fragile Five” by Morgan Stanley “strategists”. These include the South African rand, Brazilian real, Indian rupee, Indonesian rupiah and Turkish lira (3 out of the 5 BRICS).

Such incandescent weakness, a surprise to so many “strategists” counting on robust global growth, in EM currencies is a pox on their economies. The conventional explanation is the reversal of “hot money” from those economies, with the prospect of “developed” economy interest rates rising to something more appealing. This narrative follows the mainstream script of investors simply chasing yield.

That is true in at least one sense, but desperately incomplete. If it were only a reversal of foreign flows we could be mostly assured that economic problems were limited to somewhere else. Even if that observation were slightly broadened to incorporate carry trades into the responsibility for “hot money”, it still misses a great deal of relevant analysis. This is a dollar problem, and thus a reserve currency issue.

Like so many events in history, there is a close historical precedence here. If you go back and retrace the Asian flu, same thing happened largely as we see now; almost a template. In the 1997 case, the Thai baht and Indonesia rupiah were first because they were the “weakest”, countries with a high degree of dollar vulnerability owing to current account deficits and external debt. But the weakest were only the beginning, the low hanging fruit for currency vigilantes riding a crest of dollar volatility paradigm shifts.

Eventually the flu infected currencies that were erstwhile “healthy”, including Singapore. In Hong Kong, another of the “healthy” currencies, the monetary authority (under a currency board format) was forced to raise short-term interest rates above 20% to defend the dollar peg.

Even larger economies, including Korea and Japan, were totally engulfed. By November 1997, one-fifth of the 30 largest businesses in Korea were bankrupt, with speculation that half of those 30 chaebol were close to the edge. Kia Motors was one that was placed into reorganization, in bankruptcy with $10.7 billion in debt and about 60,000 workers. Korea was forced in December 1997 to obtain dollars from a coordinated bailout, with $20 billion coming from the IMF (with its restrictions) and another $35 billion from Japan, the US and the Asian Development Bank.

In Japan, Sanyo Securities (seventh largest stock brokerage firm) filed for bankruptcy on November 3, 1997, followed by Hokkaido Takushoku and then Yamaichi Securities. It was feared the Japanese banking system, still hobbled by the 1989 collapse, was about to finally and fully implode. The economic contraction in Japan was so severe, that in February 1999 the Bank of Japan, for the first time in monetary history, instituted ZIRP (and still counting).

The financial element extended everywhere, including US markets. The DJIA ran through a market-wide circuit breaker for the first time on October 27, 1997, falling 554.26 points (-7.18%) or the 10th largest single-day decline in percentage terms. The 350 point decline at 2:36 pm triggered a 30-minute halt; the re-opening did nothing to stop the selling which closed the exchange for the day at 3:30 pm.

That’s a lot of carnage starting so small, and “fragile”. In terms of timing, it took about eight months between the first Thai failure and the Dow crash. Somprasong Land in Thailand defaulted on Feb 5, 1997, triggering the first run on the baht. But if you go back further, Thai stocks had peaked in early 1996, and had fallen 45% by Feb 1997, so there was trouble evident months before (and largely ignored).

There are some notable differences between the Asian flu and this BRICS breakout, including the level of dollar reserves accumulated. But that is no comfort despite what the media and economics establishment continually proclaim. It matters less that a “fragile” nation has accumulated even hundreds of billions in US dollar reserves because the moment they are mobilized directly it is the end of the game. In Brazil, the Banco do Brasil has refrained from direct selling, preferring swaps (which is another big problem) to direct dollar infusions with that in mind.

But what is missing from this “hot money” narrative is that this dollar problem is not limited, it is extended to every corner (eventually) by the international exchange mechanism put in place post-1971. The eurodollar market has become the de facto successor of the gold standard of global exchange. The dollar as reserve currency means that Asian flu doesn’t stay contained, and that the global shortage of dollars (referred to as Triffin’s Paradox in the 1960’s) that ravaged markets in 2008 is still a systemic problem.

The epicenter of exchange liquidity is London dollar trading, called eurodollars, and dollars continue to get “more expensive” as we progress through what appears as another paradigm shift. I have referred to this funding curve before, noting that the majority of the “taper” uncertainty took place in the selloff between May 1 and June 24.

ABOOK Sep 2013 Hot Money Eurodollars May to June 24

It was a huge shift or flex in global dollar positioning, little wonder that EM currencies sold off so dramatically in response. But it is wrong to suggest, as many observers do, that this “rising dollar” is a “flight to safety” since it is nothing of the sort. In reality, it is an unwinding of dollar leveraged positions, including carry trades – but not exclusive to them. As we have seen in US bond markets, an expensive dollar has local ramifications as well.

From the bottom of the selloff in June 24, the dollar funding markets stabilized and retraced only slightly (while currency damage continued undeterred – once volatility is unleashed it often moves on its own).

ABOOK Sep 2013 Hot Money Eurodollars June 24 to Aug 9

Where the shorter end of the curve moved inward (cheaper/plentiful), the long end started to mal-form wider. Since mid-August, the curve has continued to selloff on the longer end as funding markets are again moving in the tighter direction.

ABOOK Sep 2013 Hot Money Eurodollars Aug 9 to Sep 4

Even the shorter end, late 2014 and 2015, is again seeing slightly tighter funding conditions (though not nearly as tight as back on June 24). This kind of action will likely continue to be interpreted through funding uncertainty and volatility. This is a factor beyond the scope of local central banks since it is concentrated in the reserve currency itself, “controlled” by the global banking system through London eurodollars.

The implications here, like 1997, go well beyond just localized currency issues. While the Asian flu started small and progressed, this time we are starting big with some of the largest economies (emerging or not) in the world. The systemic dollar tightness is not something that is a foreign problem; the potential for feedback is far more than trivial, despite assurances that “tail risks” have been eliminated.

Ironically, if we view this from a certain perspective, this potential tail risk is itself an outgrowth of the central bank intention to eliminate tail risk. In other words, they aren’t eliminated at all, just reconstituted.

 

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