To devalue or deflate? That is the question
Andy Xie says that economic planners have two choices when hot money retreats on expectations of a tighter US monetary policy: devaluation or deflation, and the latter is the better long-term bet
The collapse of the Indian rupee is just the first of many financial crises that the US Federal Reserve may well trigger with the unwinding of its stimulus policy. Since 2008, the Fed has cut interest rates to zero and tripled its balance sheet. The duration and magnitude of the stimulus is unprecedented. A smaller reversal of the Fed's stimulus in the 1980s triggered the Latin American debt crisis and, in the 1990s, the Asian financial crisis. This time could be worse.
For a decade, India enjoyed the limelight in the BRIC club and received massive inflows of financial capital. The inflows went into its banking system and were lent out as consumer credit. India enjoyed a consumer-led economic boom. Despite much higher inflation than the global average, India's currency also stayed strong.
That, of course, was a typical emerging-market bubble during a global liquidity boom, a by-product of a Fed easing cycle. Even though the Fed is merely signalling the gradual unwinding of its quantitative easing programme and any rate hikes are still far away, India is already crashing. It shows how big the bubble is.
India is a poster child for an emerging-market bubble. It has run big fiscal and current-account deficits for years without being punished by the market. When the liquidity tide is rising, positive stories sell. After 2008, the hot story was the decoupling of emerging economies from the troubles in the West. It justified pouring trillions of dollars into them.
The hot money, as shown in India's case, pushed up growth but also created a bubble. India is just the first to be exposed. Many more will follow in the coming months.
Some economies haven't run big current-account or fiscal deficits and yet have experienced a credit bubble under the same forces. Hot money inflates credit growth. If that credit goes into activities that don't require too many imports, the bubble just distorts allocation of the expenditure. China, for example, has seen a massive increase in property investment, yet consumption has been depressed. Deflation would be required to shift the allocation back. That would leave behind many bad loans, proportional to the misallocations over the years.
Trouble spots may occur in unsuspecting places. East Asia, Hong Kong, South Korea and Malaysia have experienced unusually high rises in household debt levels. This has raised alarms. But, as the levels kept rising, the warnings lost credibility.
The Nordic countries have seen even higher household debt levels. They have bizarre mortgage products to rival the worst during the US bubble. Australia, a vast country with a small population, has crazy property prices. There have been many abnormalities around the world over the past six years. The odds are that they are bubbles and will burst on the Fed's reversal.
Devaluation or deflation: that is the choice for many economies. Devaluation seems preferable on the surface. It inflates away the excess credit creation. Hot money suffers because of exchange rate losses on the way out.
But, devaluation may cause widespread panic and turn into hyperinflation. Indonesia and Russia, for example, suffered this fate in 1998. A political crisis inevitably follows hyperinflation. Recovery could be a very long road after such events.
Deflation will probably cause a banking crisis. But, when the political situation is already fragile, it may be the only choice. A banking crisis could be handled through recapitalisation, funded with fiscal borrowing. As the economy recovers, the government could recoup all its money. An added benefit is that deflation bankrupts those who were most aggressive during the bubble. Such people are usually hell-bent on redistribution games, not value creation. Their demise would create space for new and value-adding businesses.
Devaluation would save these parasites who would continue to engage in redistribution. Deflation may be more painful now, but there would definitely be more gain later.
"The dollar is our currency, but your problem," former US Treasury secretary John Connally said four decades ago. The US economy was so dominant in the global economy that others couldn't influence US monetary policy. But the US is much smaller now. If a large number of economies go down because of the Fed's unwinding, the US may suffer so much that it could be forced to change its policy.
The future is more uncertain this time. There are two scenarios ahead. First, the problems around the world could scare investors into running to the US. Hence, despite a weakening global economy, the US would remain strong.
Of course, this would be a bubble; a sort of global bubble yo-yo - first, the hot money left the US and went into emerging economies in 2008. A few years down the road, the situation reverses.
Second, the US economy could dive due to the crises elsewhere. The Fed would stop its unwinding operation. What followed may be global inflation. All currencies would debase together.
Debtors would be saved, and savers would be punished. One consequence would be surging gold prices. The dollar may lose its reserve currency status, to be replaced by gold.
Whichever path the world travels down over the next 12 months, there will be lots of fireworks. It may feel like 1998.
Andy Xie is an independent economist