What Exit Strategy?: Currency Crises Under a De Facto International Dollar Standard

The Fed is considering ending tapering as unemployment rates have fallen, but the situation in emerging markets is weak as Argentina has recently devalued.

Emerging markets are vulnerable to spillover effects as developed countries start to rein in monetary stimulus, Lagarde said last week in Davos.

The next day, emerging-market stocks dropped, extending the worst start to a year since 2009, as currencies tumbled on concern that a slowdown in China and Federal Reserve stimulus tapering will trigger more outflows. Argentina scrapped some of its currency controls a day after devaluing the peso as policy makers there sought to stem a financial crisis and restore investor confidence.  

I also bring your attention to trouble in Turkey and South Africa.

While the routs in the Turkish lira and the South African rand have garnered most attention recently, there have been ructions across most EM currencies. The looming end of quantitative easing started making investors rethink the relative attractiveness of higher yielding emerging markets assets last spring. 

Central bank expansion might have stabilized the situation at home, but unwinding their balance sheet is no easy task. 

Since the sell-off of 2013, doom-mongers may argue, two things have got worse. First it has become even clearer that the rich world’s central bankers do not have much of a clue how to tame the beast they have created in the form of ultra-loose monetary policy. Ben Bernanke, the outgoing Fed chief, chairs his last policy meeting on January 28th and 29th. The Fed is expected to trim its bond purchases by a further $10 billion, to $65 billion a month. No doubt this will be accompanied by a torrent of elegant verbiage to show that the Fed is in command. But sceptics should look at Britain, where the newish central bank boss, Mark Carney, has abandoned the framework he put in place only half a year ago. It was supposed to govern the pace at which monetary policy would return to an even keel. The process of normalising central banks’ balance-sheets is going to be mighty unpredictable and disruptive.

And as a result of the expansion, there has been a boom abroad alongside mediocre growth in developed countries.

One common characteristic of all emerging countries today is that they have all shared in the colossal credit boom. Loans have been growing by double-digit rates for many years. Vietnam has already blown up—it has set up a “bad bank” to try and clean up its lenders. Perhaps more countries are yet to own up to big, bad debt problems of their own. If you want to give yourself a fright on this front consider the share price of Standard Chartered, a Western bank largely exposed to the emerging world. It has collapsed.

These problems will likely put more downward pressure on the value of currencies in developed countries as investors seek safe haven. The problem might be made worse if central banks in developing countries respond with a tightening of domestic money supplies, as this will increase demand for foreign exchange. All of this is in addition to any deflation that might occur as a result of contraction in previously booming emerging markets. Of course devaluation is also a danger, but probably the lesser of the two evils as long as it occurs as a one time devaluation.

In a world of dollarization and dollar dependence, the Federal Reserve must consider the international effects of its policy. (See this post by Lars Christiansen) The dollar serves a role similar to that of gold under the gold standard. Not surprising, the current crisis is similar to a problem that occurred under the gold standard. According to Barry Eichengreen,

When countries like Britain suffered a decline in exports, the Bank of England could restore external balance by raising interest rates [tightening] so as to discourage foreign investment. But the countries of Latin America, many of which lacked even a central bank, had no control over the direction of international capital flows. Moreover, disruptions to their export markets rendered them less desirable places to invest. Hence they simultaneously suffered declines in export revenues and in capital inflows.

Banks faced two poor options. They could devalue as gold flowed out, which tended to lead to inflation more than it increased production, or they could tighten, which would lead to deflation and a credit crunch. Central banks in emerging countries face a similar problem when central banks in developed countries cease their stimulus programs. Deflation in developed countries will attract currency abroad home, putting pressure on central banks in emerging markets to either devalue allow their currencies to devalue or contract their money stocks. Either situation is not conducive to growth and stability.

The problem is conducive to increased demand for dollars and contraction of the broader money stocks. If policy tightens as demand for dollars increase, we can expect deflation and contraction of credit. If policy makers are not careful,  tightening might lead to systemic issues as in the housing crisis.

Late Add: Lars recently wrote an enlightening post on the difference between fixed exchange rate and floating exchange rate regimes.