What Would it Take to End the Emerging Market Crisis?

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Daily FX Market Roundup 01-31-14

It is Chinese New Year and rather than publish our usual Daily FX Market Roundup – I want to address two very thought provoking questions that landed on my desk today that I thought our readers would find interesting:

Q1: What Would it Take to End the Emerging Market Crisis?
Q2: What Happens if the US Unemployment Rate Drops to 6.5% Next Week?

Q1: What Would it Take to End the Emerging Market Crisis?

Over the past 2 weeks we have seen how much damage the turmoil in emerging market countries can have on the assets of developed nations. Investors flocked into the safety of the U.S. dollar and Japanese Yen, as the Argentinian Peso (ARS), Turkish Lira (TRY), South African Rand (ZAR), Russian Ruble (RUB) and Hungarian Forint (HUF) dropped to fresh lows. Since the beginning of year the ARS lost over 18% of its value versus the dollar while the other currencies fell more than 5%. In the past 6 months, those losses have reached approximately 30% for the ARS and 10% for the ZAR and TRY. A 10% decline in a currency’s value borders on a crisis but a 30% decline is a catastrophe that sounds the alarms inside the central bank. Unfortunately, the crisis in emerging markets spilled over to developed assets with the EUR/USD dropping from a high of 1.37 to a low of 1.3490, USD/JPY falling from 105 to 101.75 and the Dow Jones Industrial Average incurring over 650 points in losses over the past week. Given the impact of the crisis in emerging markets on G10 currencies and other assets, an end to the turmoil in EM nations will bring relief to financial markets around the world.

The emerging market crisis won’t end by itself because massive current account deficits, political troubles or the lack of investor confidence are not problems that can be resolved easily especially when situation is made worse by the Federal Reserve’s policies. Of course, emerging market central banks are not sitting by idly. They have raised interest rates, devalued their currencies and loosened capital controls. Higher interest rates is generally the first strategy that central banks use to defend their currencies but as we have seen this week with the U-turn in the Turkish Lira and sell-off in the South African Rand, it is not always successful. To draw in foreign investors, the compensation in interest rates needs to exceed the potential decline in the currency.

While the situation today isn’t as dire as the 80s and 90s, the resolution to the crises in Mexico, Asia, Russia and Argentina can provide insight into how this crisis could be resolved. Starting with Mexico, the crisis was caused by excessive borrowing, a weak economy and a sudden devaluation in the currency. It was eventually ended when the U.S. intervened. President Bill Clinton reasoned that the U.S.’ third largest trading partner had to be helped and his administration arranged for $50 billion worth of loan guarantees from the U.S., Canada, IMF and BIS. When the Asian Financial crisis began 1997, it spread quickly from Thailand to Indonesia, South Korea, Hong Kong and other major economies in the region. Unsustainable debt levels and risky lending plunged the region into turmoil and as the contagion spread, U.S. equities hit record lows. The situation became so severe that the IMF had to step in with massive bailout packages ranging from $40B to $57B for some of the hardest hit nations. These countries also made major changes in monetary policies that now shape the way they manage their economies. In 1998, the IMF also stepped in to help resolve the Russian Financial Crisis but the country eventually had to devalue its currency and default on its debt. When Argentina experienced its financial crisis between 1998 and 2002, the IMF was blamed for part of the country’s demise and the only option Argentina had was to default on its debt and devalue its currency.

If today’s crisis were to worsen, coordinated interest rate hikes or devaluation by emerging market nations along with IMF liquidity could be the painful but necessary resolution that these countries need.

Q2: What Happens if the US Unemployment Rate Drops to 6.5% Next Week?

Next week will be an extremely busy one for the financial markets because we have 3 monetary policy announcements, a number of PMI and ISM manufacturing reports along with labor market data from the U.S., New Zealand and Canada. The non-farm payrolls report will be the most important especially since investors are eager to see how much payrolls will rebound after the past month’s abysmal 74k release. However we are interested in the unemployment rate, which has declined rapidly over the past 2 months. If the jobless rate maintains its current pace of improvement, it could very well reach the Federal Reserve’s 6.5% threshold next week. This possibility has led some people to wonder if the Federal Reserve will respond and our answer is no.

The central bank made it very clear that 6.5% is a threshold and not a trigger for a change in policy. By tapering asset purchases this week, they responded the improvements in the labor market. While the Fed could reduce its unemployment rate threshold, the decision would not be made until March. Also changing the threshold may not be the smartest tactic for Janet Yellen because it would only lock the central bank to another hard metric and this restriction is one of the main reasons why Bernanke suggested back in December that forward guidance would be changed to a more qualitative than quantitative measure. There are a number of Federal Reserve Presidents speaking this week and we expect all of these policymakers to take the opportunity to downplay the significance of the 6.5% rate. However if the unemployment rate declines further, they won’t be able to stop the dollar from rising and yields from recovering.

Kathy Lien
Managing Director

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