Across the Curve

The Fed has waited long enough: Debt crisis looms as dollar tipped for major spike
2017-04-12 18:58:10.454 GMTThe Fed has waited long enough: Debt crisis looms as dollar
tipped for major spike

By Ambrose Evans-Pritchard, The Telegraph
April 12 (National Post) — ANALYSIS
The world’s leading currency institute is bracing for a
dramatic rise in the U.S. dollar as the Federal Reserve rushes
to tighten monetary policy, setting the stage for a
protectionist showdown and a fresh debt crisis in emerging
markets.
Adam Posen, president of the Peterson Institute for
International Economics, said investors have badly misjudged
the confluence of forces at work in Washington. They wrongly
assume that fiscal stimulus will come to little under Donald
Trump, and that Janet Yellen’s Fed will remain dovish as the
U.S. reaches full employment.
“The Fed is going to be far more aggressive than people
think. Our view is that there will be three to four more rate
rises this year,” he told The Daily Telegraph.
This would amount to a global monetary shock, all the more
so since the Fed is also floating plans to reverse quantitative
easing (QE) with outright bond sales. This foray into uncharted
waters may come earlier than supposed, perhaps by the end of
the year.
The effect of Fed tightening would be to drain dollar
liquidity from the international financial system, the exact
opposite of what happened in the emerging market boom earlier
this decade when much of the Fed’s easy money leaked into East
Asia, Latin America and the Middle East.
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U.S. Fed’s Janet Yellen says the central bank’s focus has
shifted to holding growth gains
“We expect the dollar to rise by another 10% to 15%. The
concern is that this will suck capital out of the more fragile
emerging markets and lead to fresh capital outflows from
China,” Posen said.
“It may vary country by country but it could be like the
‘taper tantrum’. Malaysia and Brazil look vulnerable to us,” he
said, speaking at the Ambrosetti forum of global economists in
Italy.
A hawkish Fed could prove painful for investors still
hoping that central banks will come to the rescue whenever
there is a squall, be it the “Yellen Put” in the US, the
“Draghi Put” in Europe, or the “PBOC Put” in China.
The Fed is itching to show that it is not a prisoner of
Wall Street after being forced to retreat many times in recent
years. It effectively delayed rate rises last year due to
China’s currency scare. Now the coast looks clear. “Central
bankers don’t think policy should be constrained just because
somebody in the markets is going to lose money,” Posen said.
Central bankers don’t think policy should be constrained
just because somebody in the markets is going to lose money
Posen is a former rate-setter on Britain’s Monetary Policy
Committee, best known for his work with former Fed chief Ben
Bernanke on Japan’s “lost decade” and inflation targeting.
The argument is that Donald Trump will succeed in ramming
through radical tax cuts and fiscal stimulus, causing U.S.
federal borrowing to balloon. The current account deficit will
rise towards 5% of GDP.
Markets have largely written off any serious action after
the failure of Trump’s health-care plan in Congress, but that
may be a mistake. Posen said there is no “informational
content” in the health-care fiasco. It is unique. Republicans
unite more over tax cuts.
Posen said the corporate rate is likely to fall from 35%
to 25%, along with income tax cuts for the wealthy and the
middle class, and more generous tax deductions for business.
This may be “very bullish” for markets at first, but it stores
up serious trouble.
Such a policy at this late stage of the business cycle
will cause the economy to overheat, forcing the Fed to jam on
the monetary brakes, and sending the dollar through the roof.
Simon Dawson/Bloomberg Adam Posen, president of the
Peterson Institute For International Economics and former
policy maker at the Bank of England, has lots to say about
higher Fed rates, Trump economics and Brexit and non of it is
good.
Such a “loose fiscal/tight money” mix will inevitably
cause a loss of trade competitiveness, making a mockery of
Trump’s promises to boost America’s export industries and
revitalize the manufacturing base. “Trade frictions are going
to come to a head in two or three years. It is going to be a
rerun of the mid-1980s,” Posen said.
This could be a big handicap for Britain as it seeks trade
deals after Brexit. Posen suggested that the country already
risks a trade shock and a productivity squeeze as it leaves the
EU single market. “Brexit is going to be like arthritis. It
will be very painful, but it is not going to kill you. We think
you could lose a third of the City. That is not a trivial
matter,” he said.
The strong dollar episode under Ronald Reagan in the 1980s
led to epic “twin deficits” – budget and current account – as
well as the worst global trade crisis since the Second World
War, with scenes of U.S. congressmen smashing Japanese
computers on Capitol Hill with sledgehammers.
Tokyo soothed nerves by agreeing to restrain exports of
cars to the U.S. under a “voluntary” agreement. Such a formula
might prove more difficult today with China, which accounts for
60% of America’s US$500 billion trade deficit. At the end of
the day, the U.S. and Japan were close allies in the 1980s.
China is challenging the U.S. for superpower leadership on
every front.
Politicians from the G5 powers ultimately intervened to
drive down the Reagan dollar at the Plaza Accord in 1985, with
dire side-effects. That attempt to manipulate currencies in
defiance of economic fundamentals led – by a complex chain of
causality – to the Nikkei bubble in Japan, and to the 1987
stockmarket crash on Wall Street.
If Posen is right about a further 15 per cent rise in U.S.
exchange rate, this would push the Fed’s “broad dollar index”
to an all-time high of over 140. Nobody knows what this would
do to a global financial system that is more dollarized than
ever before, and arguably more leveraged to the U.S.’s
borrowing costs as well.
It is not exactly a death spiral, but it is very, very bad
Data from the Bank for International Settlements shows
that dollar debt has jumped fivefold to US$10 trillion since
2002. BIS studies suggest that a stronger dollar automatically
causes banks in Europe and Asia to shrink their balance sheets
through the effects of hedging derivatives, effectively
curtailing lending.
The latest Global Debt Monitor from the Institute of
International Finance said there has been a “spectacular rise”
in emerging market debt from US$16 trillion to US$56 trillion
over the last decade, pushing the debt ratio to a record high
of 215% of GDP.
Roughly US$7.2 trillion of these loans are in foreign
currencies. Over US$1.1 trillion of emerging market bonds and
loans comes due this year. “Refinancing risk is high,” it said.
Of course, China accounts for a large chunk of the debt,
and distorts the picture. It has huge internal savings. The
banking system is an arm of state.
“It is the left hand lending to the right hand. You cannot
really have a financial crisis in China. We actually think it
would be good for China if the Fed raises rates,” said Andrew
Sheng, chief adviser to the China Banking Regulatory
Commission. That proposition remains to be tested.
Posen said the risk for China is a vicious circle as bad
debts are rolled over, and ever more credit is wasted in
propping up obsolete state industries and zombie enterprises,
ultimately sapping the life-blood out of the economy. “This is
what happened to Japan,” he added. “It is not exactly a death
spiral, but it is very, very bad.”