The extraordinary policies implemented this year by the the U.S. Fed and fellow central bankers around the world have flooded the global economy with liquidity. In addition to jacking up asset prices and enriching the holders of financial assets around the world, extremely loose financial conditions may have triggered a change in global economic conditions towards a weaker U.S. dollar and, consequently, higher commodity prices and better prospects for emerging markets asset prices.
Global U.S. dollar liquidity, as measured by U.S. money supply (M2) added to foreign reserves held in custody at the Federal Reserve, has risen at the fastest pace ever recorded over the past year. This indicator in the past has been a very good measure of global financial conditions and is strongly correlated to economic and financial conditions in the typically “dollar short” emerging markets. The chart below shows the evolution of this indicator over time, measured in terms of year-on-year real growth. The indicator shows clearly the loose conditions during the 2002-2012 commodity supercycle which was a period of very robust performance for EM assets. On the other hand, liquidity has been tight since 2012 (when the commodity-supercycle ended), only interrupted by brief expansions in 2014 and 2016. This period of tight global dollar liquidity resulted in very poor conditions for emerging markets, particularly for those cyclical economies outside of NE Asia . Interestingly, during this long downtrend emerging market stocks had two brief periods of strength, in 2014 and 2016. Not surprisingly, the outperformance of EM stocks since April of this year has happened concurrently with a massive expansion of global liquidity.
Increased U.S. money supply, particularly at times of low growth and gaping fiscal and current account deficits, tends to be associated with a weak USD. In the past we have seen that during these periods major emerging markets, either because they practice persistent mercantilistic policies (Korea, Taiwan, China) or because they introduce “defensive” anti-cyclical measures aimed at avoiding the negative effects of “hot money” (Brazil), have accumulated foreign reserves which they hold in Treasuries at the U.S. Fed. The effects on domestic monetary policies that these efforts to manipulate currencies bring about are very difficult to neutralize and have invariably led to strong expansions in money and credit in domestic economies. This occurred intensively in the 2005-2012 period and was the primary cause of the great EM stock bubble. The opposite has taken place since 2012, with foreign reserves declining and tight credit conditions existing in most EM countries. The charts below show : 1, the progression in foreign reserves held in custody at the U.S. Fed; and 2, the year-on-year growth in these reserves.
Note the recent uptick in the second chart which indicates a recent turn in the trend of foreign reserve accumulation. This upturn has been caused by the large current account deficits that the U.S. has had with Asia this year while it has sustained consumption of imported goods through fiscal and monetary policies while both the consumption of domestic goods (services) and manufacturing were stifled by Covid.
Is a Repeat of the 2000s in the Cards for Emerging Markets?
The current expansion of global liquidity and the weakening USD are unquestionably bullish for emerging markets. However, there are several reasons to believe that the conditions do not exist for an emerging market super-boom like we saw in the 2000s.
First, the U.S. has clearly evolved in its awareness of the negative effects that unfettered globalization has had on its working class. This means it now has much less tolerance for the mercantilistic currency manipulation practiced by allies (e.g., Korea, Taiwan) and zero tolerance for those practiced by strategic rivals (China). This reality is shown by the increasing attention given to the U.S. Treasury’s bi-annual Currency Manipulator Watchlist Report which this week added India and Vietnam, in addition to China, Japan, Korea, Germany, Italy, Singapore, Malaysia, Taiwan, Thailand, and India. Most of these countries are close strategic allies of the U.S. that in the past had been given a free-pass, but that is not likely to be the case in the future. Until now, the U.S. has not used the Watchlist to impose sanctions on trading partners, but the mood in Washington has changed and we will see what attitude the Biden Administration assumes.
This means that countries may no longer be allowed to run large current account surpluses and accumulate foreign reserves. It may also mean that countries that are subject to highly cyclical inflow of hot money will be restricted in accumulating reserves, like Brazil did in the 2000s. In that case, they will have to turn to some sort of capital controls to regulate flows.
Second, emerging markets are much more indebted than they were 15-20 years ago when the previous cycle started. This means that even if countries were allowed to manipulate their currencies, the domestic economies have much less room to absorb credit expansion without creating instability.
Finally, though valuations in EM are lower than for the bubbly U.S. market, they are much higher than they were in the early 2000s.
In conclusion, the 2020s will probably not look much like the 2000s. The U.S. is likely to be a much more cantankerous partner, and one much less willing to assume the costs of globalization.