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Fed-up? | 17th March 2015

Three reasons why the Fed should not raise rates  |  The rampant US dollar went relatively unnoticed until the end of last week as the world’s attention was diverted towards Europe and the start of Quantitative Easing (QE). It gained almost 4% against the so-called “BRICSA” and “MINT” currencies, the South Korean won and the Thai baht in the first two weeks of March. Since these countries have almost $US 870bn in dollar-denominated debt, all of a sudden the dollar’s strength appears to be the world’s weakness in the long term. And as markets are increasingly expecting a small increase in US interest rates in June, the Fed should at least consider the international consequences of that decision.

Quite apart from anything else, it highlights just how integrated the post-crisis world is through the global financial and trading systems and, increasingly, monetary policy as well. At its extreme, there is no such thing as “national” monetary policy: Central Banks, including the Fed, do not set interest rates for a closed economy. Their actions have global repercussions and at no time in recent economic history has this been clearer as June, and therefore the prospect for a hike in Fed rates, gets closer.

Delta Economics is of the view that if the Fed raised interest rates it would be damaging the prospects for long- term economic growth in the US. This is not because the US economy is weak. Rather, it is because the risk of sovereign default on the dollar denominated debt becomes greater as the dollar gets stronger. Beyond the simple cost of repayment, there are three things that make default likelier and therefore the consequences for the US economy more severe.

 

1. Currency depreciation does not necessarily lead to export growth

First, it cannot be assumed that there is an automatic link between currency depreciation and greater exports. The Thai baht, for example, shows how for some countries there is an inverse relationship between the currency’s value and its trade: as the spot rate decreases (in other words the baht appreciates) trade increases (Figure 1a). This is also the case for some of the other, most indebted, Emerging Market economies: for example, Brazil ($188bn debt), China ($213,7bn), South Korea ($82.3bn) and Thailand ($14.6tn) (Figure 1b ).

 

2015-03-17_fedUp_fig01a_v03 2015-03-18_fedUp_fig01b_v05

 

Figure 1a  |  Monthly value of Thailand’s exports versus USDTHB, Last Price Monthly, June 2001-Dec 2015 (forecast)
Source  |  DeltaMetrics 2015, Bloomberg

Figure 1b  |  Selected Emerging Market currencies’ correlation with trade growth, June 2001-March 2015
Source  |  Delta Economics analysis

 

Conversely, the positive correlations are not as strong as they should be for a country to benefit from a depreciation in its currency. For South Africa and Russia there is a very low correlation indeed, while for Indonesia, India and Turkey the correlations are higher but still moderate. Only Nigeria and Mexico have stronger correlations between the value of their currency and trade. This suggests that they are in highly competitive markets (such as oil and intermediate manufactured goods) where the responsiveness of trade to a change in the value of the currency is likely to be higher.

However small a rise in Fed interest rates may be, the dollar’s value would increase and therefore make emerging market debt more expensive. Because there is not a clear-cut and positive impact on trade, Emerging Market economies are unlikely to have the export-led growth effects that will make that debt affordable.

 

2. Oil Price Losers

The dominance of oil in the structure of Emerging Market trade is made obvious by the extraordinarily high correlation between oil prices and total trade (Figure 2).

 

2015-03-18_fedUp_fig02_v04

 

Figure 2  |  Correlation of total trade with oil prices, selected Emerging Market economies, June 2001-March 2015
Source  |  Delta Economics analysis

 

The lowest correlation of trade with oil price is China at 0.81, but for countries like Indonesia and Mexico the correlation is much higher at 0.90 and 0.89, respectively. What this suggests is that trade will increase as oil prices rise and vice versa. This is simply a reflection of the importance of oil in the structure of trade of Emerging Economies: because of its dominance, its correlation with the price of oil is very strong.

But because of the oil dependency of trade for many Emerging Markets, the fact that trade will drop in real terms means that all nations are potential losers from the fall in oil prices. This is either because their revenues from oil exports have dropped or because their trade overall has dropped. Again, this makes it tougher for any export-led growth to materialise.

 

3. Over-valued EM equities

The story of Emerging Market equity growth in the period since the financial crisis is one of expectations exceeding outcomes. The extraordinary recovery of trade and economic growth after the crisis pulled capital into Emerging Markets in anticipation of growth in the future. The strong correlation of most Emerging Market equities with trade through the 2001-2015 period illustrates the strength of these expectations manifested in investments in Emerging Market equities.

 

2015-03-18_fedUp_fig03_v04

 

Figure 3  |  Correlation between emerging market equities and exports, June 2001-March 2015
Source  |  Delta Economics analysis

 

Interestingly, only China and Nigeria exhibit weaker relationships between their markets and trade. However, China’s trade is 0.94 correlated with the Hang Seng Index and Nigeria’s market is proportionately under-developed through the time period.

What this shows is that if trade falls back, there is a strong likelihood that Emerging Market equities will also fall. Consequently, this will reduce the amount of capital flows into these economies. Again, the net effect is to dampen economic strength but, equally, potentially to create a self-fulfilling prophecy: trade effects feed lower capital flows which in turn lead to a decline in trade because of a lower capital base.

 

So what does the Fed do?

The Fed should not raise interest rates unless it is prepared to write off the emerging market debt that is denominated in US dollars. Monetary policy has become international as well as national and it may well be that the United States’ long-term interests are not served by a strong US dollar. Emerging Market trade, oil prices and the value of Emerging Market currencies, and over-valued EM equities may seem unorthodox reasons for keeping interest rates on hold. But in the long term, it is the US that will lose if the debts cannot be repaid.