In an interesting PR move the staid Bank for International Settlements (BIS)- the Central bankers, banker- has tweeted the following
@BIS_org: US dollar as global unit of account in debt contracts means a stronger dollar constitutes tightening of global financial conditions.
The signs of growth in the US is positive and this has already resulted in a strengthening of the US$ against many international currencies.
Lets go back a step- so what are the major financial trends once the US Fed instituted zero interest rate?
1. Major outflow of US$ into local currencies looking for increased returns (these reduced the value of the USdollar and boosted the value of the local currencies)
2. Buoyed by stronger local currencies, and knowing that they would be buying and selling in US$, many companies borrowed and hedged in US$. The borrowing was very cheap. For example, a manufacturer in an emerging market borrows in dollars, perhaps because it sells a lot of goods in dollars and sees borrowing in dollars as a hedge. A local bank lends the dollars, borrowing from some big global bank. When the emerging-market currency is strong and the dollar is weak, that manufacturer’s balance sheet looks stronger–and the local bank sees that and lends more readily. Thus a weak US dollar can lead to a global credit boom.
This was a very positive feedback look for emerging economies like Malaysia, Indonesia, Vietnam, China etc.
But now, things are changing. The US economy is growing. What’s the impact?
The consequences of US growth, while other countries are growing slower, remaining flat or even going into recession is a likely divergence between major central banks policies. The economies that are growing face heightened inflation fears and so their Central Banks with increase interest rates- the US amongst these. Other countries stagnating or in recession will continue to have very low interest levels to stimulate growth. There will be a major divide between banking policy for the first time in a decade.
With US growth, comes the strengthening in the US dollar. When the dollar rises, though, the trend I outlined above runs in reverse, effectively tightening global financial conditions, particularly in emerging markets.
The emerging-market currency falls. The manufacturer has trouble making payments on its US dollar loans; so do its peers. Banks lend less readily. Capital investment stalls. Global money managers–the ones with lots of short-term wholesale deposits that search the world for the best yields–see a falling local currency and a weakening economy and pull money from the emerging-market banks and into the US$ strengthening it further, reinforcing this trend.
This is a very negative and vicious feedback loop for those same countries who benefited from weak US economy.
If these current economic trends persist, they likely mean
(1) a major US dollar rally,
(2) a rapid unwind of QE-induced capital flows to emerging markets, (When the US Fed slashed interest rates a huge amount of money flowed out of the States looking for better returns, typically this found its way into Developing economies like those surrounding us here in Singapore).
(3) a fall in fragile emerging-market and commodity-exporter currencies, as US investors pull out and seek to convert local currency into US$ and
(4) financial shocks capable of ushering in a new global financial crisis. The catalysts are already in position to spark a collapse in a number of fragile emerging markets if the dollar moves even modestly higher plus exposure of many companies to US$ loans- repayments significantly increase as does actual interest.
So how much could be moved from developing economies back into the US Economy in search of safer investments. Reasonable estimates range from $2 trillion (FT thinks) to $5 trillion (Business Insider). Here’s a graph from BIS Head of Research and Princeton University Professor Hyun Song Shin who views these as too low estimates, he thinks US$ 9 trillion is spread around the world.
