The dramatic events in Argentina may be the “tip of the iceberg” of a broader systemic crisis across Asia, Latin America, and Africa, the top emerging market watchdog has warned.
The Institute of International Finance said powerful contractionary forces are coming to bear as the US Federal Reserve tightens monetary policy, draining dollar liquidity and lifting borrowing costs for much of the world economy.
“Rising global interest rates beg the question whether Argentina is an idiosyncratic case or a harbinger of things to come. We worry it might be the latter,” said Robin Brooks, the IIF’s chief economist.
What has raised alarm bells is the 5.5pc rise in the US dollar index (DXY) since mid-February, a delayed reaction as the Fed reverses quantitative easing and signals a series of staccato rate rises.
A stronger dollar automatically squeezes the international financial system, often through complex hedging contracts that are poorly understood. The Bank for International Settlements estimates that offshore US dollar debt has exploded to $11.8 trillion, with a further $14 trillion of “equivalent” liabilities hidden in derivatives. This volume is unprecedented.
IIF suggested that the current situation may be more dangerous than the “taper tantrum” in 2013 when the “Fragile Five” emerging markets – then India, Brazil, Turkey, South Africa, and Indonesia – were forced to take drastic action to defend their currencies.
“Even though the underlying shock this time is smaller – the rise in long-term yields this year is roughly half that in mid-2013 – many emerging market currencies have weakened as much as or more than in 2013, a sign to us that vulnerability to rising global rates is high,” said Mr Brooks.
Alastair Wilson, director of global ratings at Moody’s, said worries are rising as a string of states fail to get grip on leverage. “Debt remains extremely high by historic standards. Significant ‘event risks’ are looming in the background,” he said.
Moody’s said capital outflows from Asia over the last month have already been roughly half the pace of the taper tantrum, with the frontier markets most exposed. Mongolia must roll over its entire debt stock (80pc of GDP) within three years. The agency has already downgraded 20 sub-Saharan countries in Africa, compared to just two upgrades.
Mauro Leos, Latin America chief at Moody’s, said Argentina was first in the firing line because of its unsustainable “twin deficits”, with the current account gap ballooning to 5pc of GDP. Foreign direct investment covers only a third of this funding need. The rest has to come from capital inflows. Foreign exchange reserves were too thin to ride out the storm.
This left the country vulnerable to a “sudden stop” if confidence snapped, which is what happened when the Macri administration bullied the central bank into cutting interest rates in January – despite surging inflation. “The message is: don’t mess with central banks,” said Mr Leos, speaking at a Moody’s forum in London.
The peso has fallen by 22pc against the US dollar so far this month. It is a debacle painfully familiar for long-suffering Argentines. The central bank has had to raise rates to 40pc. It is rapidly burning reserves trying to defend an arbitrary exchange line of 25 pesos to the dollar. It is unclear whether these drastic measures are enough.
Credit default swaps measuring risk on Argentine debt have continued rising to 450 basis points despite the decision by president Mauricio Macri to request a $30bn “flexible credit line” from the International Monetary Fund, a hated body in the country.
The IIF said a “larger packet may be needed”, given that the peso is still overvalued. Negotiations may take months, leaving the door open for capital flight. Argentines have vivid memories of the “Corralito” in 2001 when their bank accounts were frozen.
Whatever is agreed, president Macri will have to implement the “up-front” austerity that he was so reluctant to accept before. Argentina is staring into the face of recession.
William Jackson from Capital Economics said Turkey’s reliance on external finance exceeds that of Argentina. Banks have been drawing heavily on the wholesale capital markets to fund a frothy credit boom, raising “roll-over risk” if capital flows freeze up. Foreign debt exceeds 50pc of GDP.
“Turkey could ultimately be forced to follow in the footsteps of Argentina and return to the IMF. If confidence evaporates, they could find themselves in a vicious spiral,” he said.
President Recep Tayyip Erdogan, the scourge of “usury”, said defiantly in London this week that he will continue forcing the central bank to hold down interest rates if he wins re-election in June. “It may make some uncomfortable, but we have to do it,” he said.
This will drive the overheating economy towards an inflationary blow-off. The lira weakened a further 2.4pc to a record low of 4.47 against the dollar after he spoke. It has fallen 18pc this year. Five-year credit default swaps on Turkish debt surged 23 points to 263 within hours.
Former central bank governor Durmus Yilmaz said Mr Erdogan is playing with fire, risking a return to the crisis of the early Nineties. “This rhetoric is extremely dangerous and will put Turkey in a dead end street,” he told Bloomberg.
Capital Economics said Brazil, South Africa, and a long list of countries may have to keep rates higher than they would otherwise like as the US tightens, with even Romania and Chile looking stretched. The emerging market universe is already growing more slowly. China is coming off the boil. Global trade volumes have slipped. The group expects the MSCI EM index of equities to fall by a further 10pc to 15pc before touching bottom.
The fate of debtor states now hinges on the dollar. If the DXY rally fades it will take some pressure off the most vulnerable, although it will not stop their borrowing costs rising. There is no sign of such relief yet. The dollar index jumped another 0.55pc on Tuesday, a large move for the anchor currency of the international system.
Hedge funds and investors are betting that the recent dollar surge is a blip and that the secular downward slide will resume. Not all analysts agree.
David Woo from Bank of America expects the dollar to strengthen another 4pc to $1.15 against the euro this quarter. One reason is that growth has stalled in the eurozone and the trans-Atlantic yield gap is widening. Another is that US companies are repatriating offshore money under the Trump tax package.
The last time US monetary tightening rattled global markets was during the Chinese currency wobble in late 2015 and early 2016. The circuit-breaker in that episode was a sudden pirouette by the Yellen Fed. It retreated from planned rate rises and rescued China at a delicate moment.
The new Fed chairman Jay Powell is more orthodox and less inclined to mercy. In a speech earlier this month he insisted – to general consternation – that “corporate debt at risk” in China and other developing countries is a diminishing problem, and that improvements to fiscal and monetary regimes shielded many from an external shock.
“The normalisation of monetary policy in advanced economies should continue to prove manageable for emerging market economies,” he said. It was a polite way of saying “drop dead”.
~Ambrose Evans-Pritchard is International Business Editor of The Daily Telegraph.