Until quite recently, the central banks of many emerging markets have fought a losing battle against rapidly appreciating currencies. It wasn’t so much that their currencies were appreciating because of fundamentals—instead, too many US Dollar were being printed and they were searching for a home that provided returns.
Take Brazil for instance. Starting from the lows in late 2008, the Brazilian Real (BRL) appreciated from 2.40 to the Dollar all the way to almost 1.50. I have Brazilian friends who were crying to me about how expensive it was to be in Brazil. A strong currency was strangling Brazilian industry and hurting worldwide competitiveness. However, as long as iron ore prices were strong, the BRL continued to appreciate.
Of course, the Brazilian central bank tried to stop this appreciation. The way that was done was by printing BRL, selling them and using the proceeds to buy US Dollars. While that slowed the appreciation and led Brazil to accumulate sizable US currency reserves, it also stoked inflation as they introduced more BRL into circulation. (In theory Brazil sterilized some of this money printing, but sterilizing money printing is an imprecise exercise at best.) In a country experiencing inflation, lenders demand high interest rates in local currency. Therefore, Brazilian businessmen began to borrow in US Dollars at much lower interest rates. That was all fine and good, until iron ore prices dropped, and the BRL started to depreciate.
Now, Brazil is stuck. I know it is an extreme example, but imagine the guy who borrowed at a 1.55 exchange rate. Today at 2.35, he’s looking at owing 50% more than he set out to borrow, as he will be converting depreciating BRL into US Dollars to pay off this debt.
The Brazilian Central Bank can sell the US Dollars that they have acquired and soak up BRL, but the economy is weak and that would only serve to reduce liquidity in an economy that needs liquidity (think of it like QE in reverse). Meanwhile, if they don’t stop the BRL from depreciating, all of these businessmen that borrowed in USD will be in terrible shape.
Of course, it isn’t just Brazil that faces this predicament—look at Indonesia, Russian, Turkey, The Philippines, Thailand and all sorts of other countries that tried to stop their currencies from appreciating. All of those local currency units that were printed to soak up the dollars served to create a credit boom. Even worse, some of that Central Bank US Dollar liquidity made it into the local financial system as well. Bernanke’s experiment in recklessness just came home to roost in the smaller and rapidly growing countries of the world. Checkmate!!
That said, I don’t think we will have another emerging markets debt crisis like 1998. These countries have learned—they have much less corporate dollar debt than in the past. Even more importantly, government debt levels are lower and these governments have been able to borrow some of the money in local currency that can be printed in an emergency. Furthermore, currency reserves are much larger. In the short term, there will undoubtedly be pain—there already has been some—there will be more. However this is also the opportunity for investors to buy into growth right when prices are cheapest, currencies are depressed and structural reforms will be benefitting the local economies.
The great thing about a currency crisis is that changes are made—sometimes rapidly—large investment projects that have been stalled for nationalist or political reasons or simply for the desire for corruption get suddenly fast-tracked. A bit of fear is good for most countries. It lets them address their issues and do it with a weaker currency—which is always good for domestic industry.
I don’t think most emerging market investors realized just how important Bernanke’s money printing was in terms of transmitting liquidity to emerging market economies. When you look at the recent currency charts, you realize just how illiquid these currencies are when foreign investors want out at the same time. As this transmission mechanism goes into reverse, central banks will be selling dollars to soak up local currency units—the next shoe to drop is slower credit growth in emerging markets, which will lead to slower growth and an even weaker currency—it is a dangerous feedback loop. In addition, when they sell dollars, they are most likely selling US Treasuries that they’ve purchased with those dollars. The whole world is on the Bernanke Standard.
For this reason alone, I don’t think he can stop printing—it will just be too painful to all of our partners around the world who are actually driving the world’s growth. It is one thing to threaten a taper—it is another to actually go through with it. He cannot let the world unwind. At some point in the next few weeks or months, there will be an amazing opportunity to buy emerging market assets at silly prices. People don’t realize that the growth is still there, and valuations are suddenly becoming attractive—right as these companies get more competitive as their currencies depreciate.
For the past century, the guys with access to US Dollars at the lows were the ones who made fortunes—we are part-way through another emerging markets currency crisis. Get ready to make your shopping list and bet on the assets that are the most beaten down, in the fastest growing countries.