A new golden age for the dollar is dawning, according to some analysts, and this will bring deepening trouble for emerging markets.
A little noticed Goldman Sachs forecast at the end of August predicted the euro falling to $1.15 by the end of 2015, and by the end of 2017 reaching parity with the dollar. The forecast is an outlier, with other investment banks forecasting the dollar staying in the range of $1.15-25 to the euro. But the forecast does not seem wayward amid strengthening expectations that a new golden age for the US economy is dawning, bringing it with a dollar bull market - and major problems for emerging markets.
Although just starting, - the current dollar rally began in July - the new turn towards the dollar following the end of quantitative easing in 2013 may already be prompting a collapse in emerging markets currencies: Russia's ruble crossed a psychological rubicon of 40 rubles to the dollar on October 6, and is down more than 20% since the start of the year; the Brazilian real has sunk to its lowest level against the dollar since 2008; Indonesia's rupiah has hit a seven-month low against the dollar; the Mexican peso and South Korean won, Turkish lira and South African rand all fell sharply in September. JPMorgan. JPMorgan's EMCI Index - which measures emerging market currencies - is now below its 2007 low point.
"The depreciation of emerging market exchange rates looks a lot like a subset of the sharp appreciation of the dollar, which has also shot higher against the yen and the euro, than it does a weakness of the entire asset class," Alan Beattie blogged in the Financial Times on October 2.
What is the reason for the change in exchange rates and why has it started now? "The combination of healthy post industrial growth and self-sufficiency in cheap energy makes the US economy almost invulnerable," says Aleksei Tretyakov, director of Moscow investment company Aricapital, writing in Russia' leading business daily Vedomosti on October 7. The Fed's quantitative easing programme worked perfectly to reload the economy without sparking inflation. "But cheap money is only part of the story, the basic factor of growth has been the shale gas and oil revolutions," argues Tretyakov.
Oil production has grown by one million barrels a day over the best part of the last decade, "equivalent to the annual appearance of a new oil sheikdom like Azerbaijan or Columbia,” he says. In 2014 the US has become the world's number 1 producer of petroleum liquids ahead of Russia and Saudi Arabia, with the US energy ministry forecasting growth to continue at the same rate until 2019.
The shale revolution has created around 536,000 work places in the US, according to Tretyakov, a 3% increase in employment. The economic boom combined with budget cuts has caused the previous economic bogeymen of twin US trade and budget deficits evaporate in the sunlight.
The boom in the US and stagnation in Europe will spark a bull market in the dollar. But, because of the shale revolution, this is unlikely to reload the commodities cycle to support emerging markets. Instead, it will hammer emerging markets by unwinding the crucial emerging market currencies carry trade - the borrowing of cheap dollars to buy appreciating EM currencies, analysts fear.
"Carry trades are already being unwound. But a higher US dollar, higher US borrowing costs, and deteriorating EM asset returns mean there's most likely a long way to go," warns currency commentator George Magnus. "Liquidity will be sucked out of the global system, precisely the opposite of what happened when the US dollar bear market was in full flow," Magnus forecasts.
This will bring huge pressure to bear on emerging markets, as happened during the two previous US dollar bull markets, 1978-1985 and 1992-2001, which were twinned with the Latin American debt crisis of the 1980s and the 1997 Asia crisis respectively. "It's quite likely that EM will be in the crosshairs this time too," says Magnus.
What will emerging markets' policy response be as their currencies decline against the dollar? The options are limited. "Countries currently without pegs or explicit targets are unlikely to adopt them now," believes Beattie, with central banks not willing to risk limited foreign reserves. Secondly capital controls are an unlikely choice, following Thailand's disastrous move in 2006 to introduce capital controls, sparking the largest stock market crash in its history.
"The old exchange rate policy dogmas are long gone. Asia, and emerging markets in other regions, have shown tolerance, allowing their exchange rates to drop against the US currency, though not always without some monetary restraint to brake the decline in their own currencies," agrees Magnus.
"The falls in currencies over the past month have been substantial, but they do not represent panic or hysteria, and policymakers would do well to prevent things getting worse by overreacting," Beattie believes, pointing out that the decision by Thai authorities in 2006 to impose capital controls prompted the Thai stock market to collapse to a historic low.
What does this mean for Russia? Bloomberg September 30 reported Russian authorities to be considering capital controls, instantly prompting the ruble to jump out of its trading corridor and around $700m in central bank intervention, despite the fact the Kremlin vigorously denied any plans for capital controls.
"As long as [head of Russia's central bank Elvira] Nabiullina's team is in charge at the CBR, we see only a limited probability that large-scale capital controls will be introduced - a relatively orthodox policy response remains far more likely," believe analysts at Daiwa Capital. "But - particularly if events do not pan out as Russia's leadership might hope - personnel might be replaced along with current policy."
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