2014 Currency Turmoil

By Dave Cantey 2014 2-16-14

Since the first of the year, stocks have hit a soft patch. As to the cause, Fed tapering is most often blamed, and we would not disagree with this. However, concerns about emerging markets have also surfaced. Why problems in the emerging market economies are troublesome has not been explained. Today, we wish to shed some light on this issue. Below is a chart of the currencies most often referenced in this regard. Notice, over the past year, these five currencies Indonesia, India, Brazil, South Africa, and Turkey, taken together, have declined in value by roughly 20%, which is a very big move by any criteria. When a countys currency devalues by 20%, it experiences a corresponding increase in local inflation, and its poor and middle class suffer. So, what is going on here? It should come as no surprise that the money printing by the US Federal Reserve is at the root of this problem. Stay with us here as we take you step-by-step through the process. First, starting with QE1 back in 2008, during the US banking crisis, the US Fed took interest rates down toward zero. As US and European rates declined, investor money flowed into emerging market debt in search of yield. These emerging market capital in-flows encouraged local spending and investment, which helped stimulate these local economies. All this was fine for a while. But then, back in July of 2012, world-wide interest rates bottomed and began rising. Slowly at first, funds started draining back out of emerging market debt, and back into the more developed countries. During 2013, interest rates moved higher. At the same time, US and European stocks were soaring, which beckoned capital flows back into the stock market. In the second quarter of 2013 we saw interest rates spike, and an acceleration of capital flight, as it is called, which directly caused the above currencies to swoon. To stem the capital flight, Turkey, for example, raised its short-term interest rates by nearly five percentage points, which did little more than slow its already weak economy. History shows that currency controls never work, and the currency in question always ends up going down to find equilibrium, where it wanted to go in the first place. The significance of this for the dollar is that, one fine day, the dollar will also experience the very same capital flight. Why? For the same reason, because foreigners own the majority of US sovereign debt. One day, relatively soon, but not in 2014 (Europe has to fail first), these foreigners will want their capital back (think China and the Far East), and the dollar will plunge, causing significant local inflation, which will hurt the poor, and the middle class. Historically, the US has relied on its Reserve Currency status to postpone this inevitable outcome in the face of its tremendous Debt Bubble. But today, 23 countries have already begun doing cross-border transactions in currencies other than the dollar. These countries represent 60% of the world GDP. As these non-dollar transactions become more prevalent, the dollars superiority will become more tenuous. The linchpin in all this, believe it or not, is Saudi Arabia. Yes, because as long as Saudi Arabia sells its oil in dollars (petro-dollars), the dollar will remain sound. But when Saudi Arabia switches increasingly to other currencies, the dollar will be doomed.