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     Aug 20, '13

Reckoning is due
By Martin Hutchinson

Emerging-market stocks have underperformed the US market by some 35% in 2013. That's because investors, remembering the Asian financial crisis of 1997-98, believe emerging markets will be zapped badly when money tightens. But that belief may be wrong: many emerging markets have pursued more responsible policies than rich countries since the 2008-9 recession and are consequently in much better shape. This time around, it may be the wealthy West that suffers most when money tightens, in particular experiencing an unexpected burst of inflation.

The explosion in global liquidity since the late 1990s is startling. Emerging market central banks, in particular, have shown a huge

appetite for the dubious paper of the US Treasury and even of the housing agencies, Fannie/Freddie insolvencies or no.

According to the International Monetary Fund's COFER database, global foreign exchange reserves increased from US$1.6 trillion to $11.1 trillion over the 15 years between 1998 and 2013, an annual rate of increase of 13.8%, three times the 4.5% increase in nominal gross world product during the period.

Emerging markets, in spite of representing much less than half of the world's economy (on a market exchange rate basis), own two-thirds of these reserves or $7.4 trillion, compared with 38% of the much smaller reserves in 1998.

Since some 62% of the world's reserves are held in US dollars, this could explain the lack of global and US inflation, in spite of the excessive increase in US money supply. After all, US M2 increased from $4.2 trillion to $10.6 trillion in the 15 years 1998-2013, a rate of increase of 6.4% per annum, about 50% faster than the increase in nominal GDP during the period. However the increase in dollar holdings of international central banks was roughly $5.8 trillion (assuming unallocated reserves in the IMF COFER database are distributed in the same proportion as allocated ones).

Hence, with a $6.4 trillion increase in US M2 money supply in 1998-2013 and roughly a $5.8 trillion increase in sterile holdings of dollar assets by the world's central banks in the same period, nine tenths of the extra M2 money the Fed created had a velocity of zero. It went straight into central bank vaults, facilitated no transactions and consequently caused no inflation.

In the past year, the US has created an additional $670 billion of M2, while international dollar reserves have increased by approximately $470 billion - which suggests that somewhat more of the new M2 money may be flowing into transactions and causing inflation than was previously the case.

If the high reserve countries such as China, Japan, Singapore and Taiwan were to spend their reserves, this process would go into reverse and inflation would appear without a corresponding increase in the M2 money supply.

If for example China suddenly discovered the $2 trillion hole in the balance sheets of its banking system (since all the empty office buildings and apartment buildings constructed in 2008-10 are worth very little) its natural response would be to sell $2 trillion of its $3.2 trillion of foreign exchange reserves, perhaps $1.4 trillion of which sales would be in the form of US Treasury bills and bonds and housing agency bonds. It would then give the money to its domestic banks to plug the holes in their balance sheets. The banks would use the money to pay bills and refund depositors, pushing it into the global financial system.

This would have two effects. First, there would be an additional $2 trillion of money in the world economy in the form of transactions, as the Chinese banks spent their lifeline. Second, the US Treasury and the housing agencies would suddenly have to find $1.4 trillion worth of additional buyers for Treasury and Agency debt. Even if the Fed is still at that point buying $85 billion of debt a month ($1.02 trillion a year) interest rates would rise sharply.

Overall, the US economy would not only suffer much higher interest rates, causing a substantial recession and a stock market crash, but also a sharp burst of double-digit inflation as the extra active money fed into prices. This would be retribution for the misguided monetary policies since 1995 and fiscal policies since 2001, suffered all at once, and it would be very painful.

In practice, it's unlikely the Chinese government would choose to recognize its $2 trillion bad debt problem all at once - for one thing, such a solution would be extremely inflationary for the domestic Chinese economy. However the flood of easy money around the world, now joined by Japan's "Abenomics" stimulus is having its usual effect of a huge tsunami of "malinvestment," to use the Austrian economic term.

Stock market valuations are rising to unprecedented heights, especially in the United States, while corporate deals and real estate investments are proceeding at a rapid pace fueled by low interest rates and high liquidity. Meanwhile interest rates are quietly creeping up - the 10-year Treasury bond yield at around 2.7%, is already a full percentage point above its nadir last year. At some point, almost certainly within the next 12-18 months, a crisis of confidence must occur.

When that happens, the four BRIC emerging markets (Brazil, Russia, India and China) will be in an especially difficult position, because the forces of malinvestment have been strongest in their newly fashionable but fragile economies.

China, as described above, has about $2 trillion of bad debts in its banks - an amount it can easily afford to re-finance, except that it will have to use a substantial part of its massive foreign exchange reserves to do so. India has gone ex-growth; its principal need is a new government to resume the reform process that was aborted by the 2004 election, which brought back the socialist Congress party. Its public sector is bloated and corrupt, and on a consolidated basis runs budget deficits of around 10% of GDP, sucking up domestic savings for unproductive uses.

Brazil, like India, has had a grossly overspending government for the last decade and has reversed in practice much of the privatization of the 1990s, with government meddling heavily in the management of theoretically privatized companies. As for Russia, it is a kleptocracy sustained only by $100 oil. A credit crunch will destabilize all four BRIC economies, forcing them to devote their large central bank reserves to domestic needs.

The spend-down of central bank reserves will thus happen simultaneously in a number of countries. It will both place an immense strain on the US Treasury market and bring a wholly unexpected and substantial surge in inflation, which will quickly reach double-digit levels. Countries that have over-expanded their money supply, notably the US, Japan and Britain, will find themselves suffering a double-edged problem of sharply rising interest rates and virulent inflation.

Meanwhile the eurozone, which has expanded its money supply less, will suffer less inflation - unless the depression in southern Europe causes Germany's Bundesbank to release the $700 billion of "Target 2" balances accumulated there through the ill-designed euro payments system.

In previous recessions, credit crunches of this kind, even without the inflation, have been especially cruel to emerging markets - one need only think of the deep recessions suffered by Mexico in 1995 and by the East Asian countries in 1997-98.

This time around, however, emerging markets in general (except for the badly run and over-fashionable BRICs and a few others) have been much more prudent than their Western cousins. South Korea, for example, has a budget in modest surplus and interest rates that are generally in excess of the inflation rate. It also has $326 billion of foreign exchange reserves, so there is no chance of a funding crisis.

The "bad boys" of Latin America - Argentina, Venezuela, Bolivia, Ecuador and Nicaragua - will suffer the painful results of their folly in a crisis, as commodity prices decline and they run out of money. However conservatively run countries, such as Chile, Colombia, Peru and Mexico, have run only modest budget deficits, have built up foreign exchange reserves or separate stabilization funds, and have kept interest rates at least comparable to their level of inflation. Consequently they will suffer only mildly in the downturn, and will gain in living standards and wealth relative to other countries.

In Africa, the better run countries have not been able to borrow excessive amounts and have been conservative on interest rates and budget balances because they have had to be (newly oil rich Ghana is a notable exception to this, alas). Since the benefits of their new technology-enabled connections to the global economy and their abundant cheap labor will remain, they should relatively prosper. Like the Industrious Apprentices of Latin America, they will suffer only modest inflation and will rise up the pecking order of global economic well-being.

In the last 20 years, fiscal and monetary profligacy has appeared to carry almost no cost, at least for the wealthy Western economies. Thanks to the gigantic stores of wealth in a relatively few central banks, the excess money supply has been sterilized. The reckoning is however overdue, and it will be a painful one.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.

(Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)




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