Two weeks ago this column warned that “Asia should prepare for squalls”. With the US dollar appreciating at the same time as the price of oil was going up, some of the region’s more fragile economies, including Indonesia, Malaysia and India, could soon face formidable financial headwinds.
Since then, things have only got worse. The US dollar has continued to appreciate, climbing another 2 per cent against a widely followed reference basket of major currencies. And the price of Brent blend crude oil has made further gains, touching US$80 a barrel on the collapse of production in Venezuela and the prospect of renewed US economic sanctions against Iran.
So far the impact has been felt most brutally beyond East Asia, in countries that rely most heavily on short-term US dollar financing. Argentina is in emergency talks to secure a bailout from the International Monetary Fund. And in Turkey, the local currency has now fallen 20 per cent against the US dollar this year, with President Recep Tayyip Erdogan fulminating against a foreign plot to unseat him, and his political allies condemning “dollar terrorism”.
These effects may be largely local and as yet isolated. But that hasn’t stopped noted economic luminaries sounding the alarm, cautioning that more widespread trouble may be on the way. Last week, Nobel-winner Paul Krugman warned of “a classic 1997-98 style self-reinforcing crisis”. A few days earlier, respected Cuban-American economist Carmen Reinhart had warned that emerging market economies are a lot more vulnerable now than they were either during the 2013 “taper tantrum” mini-crisis, or during the 2008 global financial meltdown.
What’s got these economic bigwigs so wound up is the sheer amount of US dollars that companies in the developing world have borrowed over the last few years. With the US Federal Reserve busy printing money in the years following the 2008 financial crisis, and with the US dollar weak until mid-2014, US loans were cheap and easy to repay. By 2015, according to the Bank for International Settlements, the most credible of all the world’s multilateral financial institutions, corporations in emerging markets had accumulated some US$3.3 trillion in US dollar debt.
Economists fret that a stronger US dollar will make those debts more expensive to service and far tougher to repay or rollover. As the dollar appreciates against developing world currencies, borrowers struggle to meet their interest payments from local currency cashflows. Many rush to buy dollars to cover their obligations, which pushes the US currency higher and exacerbates the problem. Some borrowers default and go out of business, which sours sentiment towards the local economy. That puts fresh downward pressure on the local currency and the vicious circle continues.
Worse, as foreign investors take losses on assets in one emerging market, they are forced to reduce their exposure to risk by selling assets in others. As a result, financial and economic stress spread by contagion from fragile economies to those that were previously thought strong and immune to infection. Pretty soon you have a full-blown international financial crisis on your hands.
So how real is this danger today? Clearly, a lot depends on which way the US dollar moves from here. If it continues to strengthen over the coming months, that US$3 trillion will begin to look like an emerging markets time bomb on a short fuse to detonation. Conversely, if the dollar weakens again, the fears of a crisis will blow over, leaving only a few isolated trouble spots in problem economies like Turkey.
Happily, there are good reasons to believe that the current spike in the US dollar, although painful, should prove short-lived. To understand why, it’s necessary to go back to the beginning of this year.
At the time, the general feeling among economists and investors was that after some seven years of steady growth, the US was approaching the late stages of its economic cycle, with growth set to turn down. By contrast, in other major economies, notably the euro zone and Japan, growth was recovering promisingly after protracted local downturns.
With the expected marginal changes in relative growth favouring Europe and Japan, investors built up large short positions in the US dollar. But then data from the non-US economies proved surprisingly soft – Japan’s output actually contracted in the January-March quarter – while activity in the US continued to tick over nicely.
As sentiment reversed, the short US dollar position began to look like an uncomfortably crowded trade and at least some investors moved to cover their positions, pushing the US dollar higher.
In the near term, that unwinding could still have further to run. But the underlying conditions have not changed greatly. The US economy is undoubtedly nearing the end of its economic upcycle. With unemployment at its lowest since 2000, economists judge that activity is running above its long term potential rate. That means the additional demand created by Donald Trump’s tax cuts will flow largely to overseas economies, widening the US trade deficit, supporting growth in the rest of the world, and weighing on the US dollar.
So while there is a chance that US dollar strength could become a self-fulfilling prophecy, causing a new emerging markets panic, the probability is small.
It is far more likely that the present run-up in the US dollar is merely a normal counter-trend rally that will soon reverse.
And when it does, fears about a fresh 1997-type meltdown in Asian economies will be quickly forgotten – at least until next time. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years