This week’s Outside the Box continues with a theme that I and my colleague Worth Wray have been hammering on for some time: the very real potential for a rising dollar to trigger the next global financial crisis.
We are concerned about the consequences of multi-speed economic growth around the world and the growing divergence between major central banks. In our opinion, if these trends persist, they likely mean (1) a major US dollar rally, (2) a rapid unwind of QE-induced capital flows to emerging markets, (3) a hard slide in fragile emerging-market and commodity-exporter currencies, and (4) financial shocks capable of ushering in a new global financial crisis.
Alongside true macro legends like Kyle Bass, Raoul Pal, Luigi Buttiglione, and Raghuram Rajan, Worth and I have written about this theme extensively in 2014 (“Central Banker Throwdown,” “Every Central Bank for Itself,” “The Cost of Code Red,” “Sea Change,” “A Scary Story for Emerging Markets”). Now it’s quickly becoming a mainstream macro theme on almost everyone’s radar. Virtually every economist and investment strategist on Wall Street has a view on the US dollar and the QE-induced carry trade into emerging markets… and anyone who doesn’t should start looking for a different job.
Policy divergence is really the only macro theme that matters right now. And on that note, the Bank for International Settlements just released its predictably must-read quarterly review, with an urgent warning:
The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on EMEs [emerging-market economies]. For example, it may expose financial vulnerabilities as many firms in emerging markets have large US dollar-denominated liabilities. A continued depreciation of the domestic currency against the dollar could reduce the credit worthiness of many firms, potentially inducing a tightening of financial conditions.
@BIS_org: US dollar as global unit of account in debt contracts means a stronger dollar constitutes tightening of global financial conditions.
This is in spite of continued efforts by central banks to ease monetary conditions. Calling attention to that very risk in our Halloween edition of Thoughts from the Frontline, Worth explained that the catalysts are already in position to spark a collapse in a number of fragile emerging markets if the dollar moves even modestly higher (into the low 90s on the DXY Index); but we have struggled to quantify the actual size of the nebulous USD-backed carry trade that could now come unwound at any moment.
Reasonable estimates range from $2 trillion to $5 trillion. The true number could be even larger if more speculative money has slipped through the cracks than has been officially reported in places like China; or it could be smaller if a significant portion of recent inflows represents a more permanent deepening of emerging-market financial systems rather than an attempt to escape financial repression in the developed world. It’s hard to know for sure, and that’s why this week’s Outside the Box is so important.
In a recent presentation at the Brookings Institution, BIS Head of Research and Princeton University Professor Hyun Song Shin shared his research revealing that dollar-denominated credit to non-bank offshore borrowers is now more than $9 TRILLION and at serious risk in the event of continued policy divergence.