The world’s leading currency institute is bracing for a dramatic rise in the US dollar as the Federal Reserve rushes to tighten monetary policy, setting the stage for a protectionist showdown and a fresh debt crisis in emerging markets.
Adam Posen, president of the Peterson Institute for International Economics, said investors have badly misjudged the confluence of forces at work in Washington. They wrongly assume that fiscal stimulus will come to little under Donald Trump, and that Janet Yellen’s Fed will remain dovish as the US reaches full employment.
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“The Fed is going to be far more aggressive than people think. Our view is that there will be three to four more rate rises this year,” he said.
This would amount to a global monetary shock, all the more so since the Fed is also floating plans to reverse quantitative easing (QE) with outright bond sales. This foray into uncharted waters may come earlier than supposed, perhaps by the end of the year.
The Peterson Institute for International Economics believes Janet Yellen’s US Fed will have ‘three to four more rate rises this year’. Photo: AP
The Fed flow-on
The effect of Fed tightening would be to drain dollar liquidity from the international financial system, the exact opposite of what happened in the emerging market boom earlier this decade when much of the Fed’s easy money leaked into East Asia, Latin America and the Middle East.
“We expect the dollar to rise by another 10 to 15 per cent. The concern is that this will suck capital out of the more fragile emerging markets and lead to fresh capital outflows from China,” Mr Posen said.
“It may vary country by country but it could be like the ‘taper tantrum’. Malaysia and Brazil look vulnerable to us,” he said, speaking at the Ambrosetti forum of global economists in Italy.
A hawkish Fed could prove painful for investors still hoping that central banks will come to the rescue whenever there is a squall, be it the “Yellen Put” in the US, the “Draghi Put” in Europe, or the “PBOC Put” in China.
If the US dollar rises sharply, it could spark a fresh global debt crisis. Photo: Amr Nabil
The Fed is itching to show that it is not a prisoner of Wall Street after being forced to retreat many times in recent years. It effectively delayed rate rises last year due to China’s currency scare. Now the coast looks clear. “Central bankers don’t think policy should be constrained just because somebody in the markets is going to lose money,” Mr Posen said.
Mr Posen is a former rate-setter on Britain’s Monetary Policy Committee, best known for his work with former Fed chief Ben Bernanke on Japan’s “lost decade” and inflation targeting.
China accounts for a large chunk of global debt. Photo: AP
The argument is that Donald Trump will succeed in ramming through radical tax cuts and fiscal stimulus, causing US federal borrowing to balloon. The current account deficit will rise towards 5 per cent of GDP.
Markets stay calm
Markets have largely written off any serious action after the failure of Mr Trump’s health-care plan in Congress, but that may be a mistake. Mr Posen said there is no “informational content” in the health-care fiasco. It is unique. Republicans unite more over tax cuts.
Mr Posen said the corporate rate is likely to fall from 35 per cent to 25 per cent, along with income tax cuts for the wealthy and the middle class, and more generous tax deductions for business. This may be “very bullish” for markets at first, but it stores up serious trouble.
Such a policy at this late stage of the business cycle will cause the economy to overheat, forcing the Fed to jam on the monetary brakes, and sending the dollar through the roof.
Such a “loose fiscal/tight money” mix will inevitably cause a loss of trade competitiveness, making a mockery of Mr Trump’s promises to boost America’s export industries and revitalise the manufacturing base. “Trade frictions are going to come to a head in two or three years. It is going to be a rerun of the mid-1980s,” Mr Posen said.
This could be a big handicap for Britain as it seeks trade deals after Brexit. Mr Posen suggested that the country already risks a trade shock and a productivity squeeze as it leaves the EU single market. “Brexit is going to be like arthritis. It will be very painful, but it is not going to kill you. We think you could lose a third of the City. That is not a trivial matter,” he said.
The strong dollar episode under Ronald Reagan in the 1980s led to epic “twin deficits” – budget and current account – as well as the worst global trade crisis since the Second World War, with scenes of US congressmen smashing Japanese computers on Capitol Hill with sledgehammers.
Tokyo soothed nerves by agreeing to restrain exports of cars to the US under a “voluntary” agreement. Such a formula might prove more difficult today with China, which accounts for 60 per cent of America’s $US500bn (??400bn) trade deficit. At the end of the day, the US and Japan were close allies in the 1980s. China is challenging the US for superpower leadership on every front.
Politicians from the G5 powers ultimately intervened to drive down the Reagan dollar at the Plaza Accord in 1985, with dire side-effects. That attempt to manipulate currencies in defiance of economic fundamentals led – by a complex chain of causality – to the Nikkei bubble in Japan, and to the 1987 stockmarket crash on Wall Street.
If Mr Posen is right about a further 15 per cent rise in US exchange rate, this would push the Fed’s “broad dollar index” to an all-time high of over 140. Nobody knows what this would do to a global financial system that is more dollarised than ever before, and arguably more leveraged to the US’s borrowing costs as well.
Global debt worries
Data from the Bank for International Settlements shows that dollar debt has jumped fivefold to $US10 trillion since 2002. BIS studies suggest that a stronger dollar automatically causes banks in Europe and Asia to shrink their balance sheets through the effects of hedging derivatives, effectively curtailing lending.
The latest Global Debt Monitor from the Institute of International Finance said there has been a “spectacular rise” in emerging market debt from $US16 trillion to $US56 trillion over the last decade, pushing the debt ratio to a record high of 215 per cent of GDP.
Roughly $US7.2 trillion of these loans are in foreign currencies. Over $US1.1 trillion of emerging market bonds and loans comes due this year. “Refinancing risk is high,” it said.
Of course, China accounts for a large chunk of the debt, and distorts the picture. It has huge internal savings. The banking system is an arm of state.
“It is the left hand lending to the right hand. You cannot really have a financial crisis in China. We actually think it would be good for China if the Fed raises rates,” said Andrew Sheng, chief adviser to the China Banking Regulatory Commission. That proposition remains to be tested.
Mr Posen said the risk for China is a vicious circle as bad debts are rolled over, and ever more credit is wasted in propping up obsolete state industries and zombie enterprises, ultimately sapping the life-blood out of the economy. “This is what happened to Japan,” he added. “It is not exactly a death spiral, but it is very, very bad.”