Gavekal Explains The Emerging Market Panic

Tyler Durden's picture

Submitted by Charles Gave and Louis Gave via Evergreen Gavekal,

With emerging markets in panic mode, investors are bound to be reminded of the enduring observation, first made by a 19th century British businessman named John Mills, that: “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works.” With that in mind, investors seem happy to link the ongoing emerging market sell-off to either a) China’s large capital misallocation triggered by the 2008-11 credit boom or b) the Federal Reserve’s promise to start tapering last May, followed up now by the real thing. But could there perhaps be another explanation?

As everyone knows, the US dollar is still the world’s reserve currency. If/when the Fed maintains negative real rates for an inordinately long period of time, fewer and fewer people choose to save in US dollar and the currency heads lower. However, the dollar does not go down forever. When the exchange rate becomes between one or two standard deviations undervalued on a purchasing parity basis, it stops falling, if only because foreigners start loading up on US assets (Brazilians buying condos in Miami, Russians in New York city, etc.). Still, as long as real rates in the US are negative, the Fed, for all intents and purposes, is signaling that it does not want the dollar to rise and so it duly remains undervalued—an undervaluation which amounts to a “false price.” Combine this “false price for the currency” with the “false price in the cost of capital,” and the odds of a considerable misallocation of capital go through the roof. As to misallocation due to dollar undervaluation, this chiefly occurs through three mechanisms:

First, a weak dollar leads to a fall in the value of investments made outside of the US. Such investments would have been perfectly profitable but for dollar undervaluation; meanwhile, marginally profitable activities which should have disappeared in the US do not, lowering overall productivity as US “zombie” companies survive.


The second effect is a huge “improvement” in the US trade balance, usually with a lag of roughly three years. Since 2006, the US current account deficit has narrowed by nearly 4 percentage points of US GDP—for countries on the other side of this “improvement,” this adjustment can be painful.


The third effect is more complex. The dollar is the world’s reserve currency, which means the US is the only country in the world which has no foreign trade constraint. However, as we reviewed in our recent book (see Too Different For Comfort), this also means that the US current account deficit needs to grow if global trade is to expand. Indeed, if the US starts to export fewer dollars, then someone, somewhere will find he is unable to finance his trade. The US current account deficit is the monetary base of world trade and a reduction in the US current account deficit is thus equivalent to a massive monetary tightening for the rest of the world. It is for this last reason that we spend so much time monitoring the growth of central bank reserves held at the Fed; for as long as these are expanding, there are few reasons to fear a hiccup in the global trade architecture. However, as soon as central bank reserves start to shrink, then countries running large current account deficits and/or large budget deficits may find pushing more debt through the system challenging. Excluding China, reserves at the Fed are contracting in real terms.

Which brings us to what is unfolding today. The point that we have made for the past six months is that, within the emerging market space, there were clear weak spots but also countries in positions of strength. At times when central bank reserves are shrinking, the weak spots are always the countries running large current account deficits (Turkey, South Africa, Brazil, India...) or attempting to defend fixed, or artificially high, exchange rates in order to cushion the domestic financial industry silly enough to borrow in a foreign currency (Ukraine, Argentina...). Meanwhile, other emerging markets are plodding along, which helps explain why markets as diverse as the Philippines (still recovering from the most powerful Typhoon ever recorded), Indonesia (feeling the brunt of China’s more muted coal demand), Pakistan, Sri Lanka or Vietnam are all up for the year. Even Thailand is flat year to date, despite a violent political crisis.

In the meantime, we are left to ponder whether the years of the Fed following “euthanasia of the rentier” and “beggar thy neighbor” policies are now coming home to roost? After all, it’s all well and good for the Fed to hope for an increase in US “net exports,” but if the end result is to trigger a collapse in global trade (a distinct risk now that the previously fast growing economies of Latin America, Turkey, Ukraine etc., are hitting the wall while China, Indonesia and India slowing down), then it will look as if the Fed will have sown the seeds for the emerging market growth slowdown. In other words: did the Fed just do to the faster growing, deficit-generating, emerging markets what the Bundesbank did to the rest of euroland? If so, then maintaining some exposure to yield instruments in portfolios makes ample sense—if only as protection against growth expectations across emerging markets continuing to be ratcheted down—along with global trade, profits and risk appetite

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wee-weed up's picture

All it takes is one domino!

TruthInSunshine's picture

Janet Yellen gets decapitated by Ben Bernanke's Boomerang.

News at 11:00.

Stuck on Zero's picture

Was this written by Janet Yellen?  There are trillions of dollars running around out there to grease the wheels of trade.  That number increases by ~$800B a year.  The Author thinks that if we slow it down by a few measly billion all the wheels of trade will fall off? Hell, there's grease splattering everywhere.  Tell Germany and China to run huge trade losses for awhile.


nuclearsquid's picture

The hope for one domino is the only reason I will sit through what will otherwise be an excruciation speech tomorrow night.


midtowng's picture

The dollar is NOT undervalued. Other nations buy our assets so that THEIR currencies can remain undervalued.

N2OJoe's picture

I suppose, if you consider dollars to be assest and not FED liabilities.

Quinvarius's picture

LOL.  Dollar undervaluation.  That is some first class BS.  All the Fed and Treasury are signaling is pure terror it will go under 80.

LawsofPhysics's picture

indeed, if the world chooses to move away from the dollar, there won't be jack shit anybody, especially the insolvent Fed, can do.

Reptil's picture

the war machine is waiting ..

desirdavenir's picture

actually males a lot of sense if you believe,as Gavekal does, that US won't have large trade deficit thanks to shale oil. A lot of debt outside the US is on dollars, so of dollars aren't exported anymore, there is a short squeeze.

LawsofPhysics's picture

...and as the other countries start bypassing the dollar altogether?  I wonder what the outcome of a isolationst policy would be if it were forced upon the U.S.?  Basically, no one outside the U.S. wanted dollars, but rather wanted to settle any trade with something real (oil, gas, wheat, hogs, cows, etc.)

Could never happen right?

outofideas's picture

Would they take congressmen?

PT's picture

Who knows how much they would pay you to keep them away from their country?  Although the mere offer may be interpreted as a declaration of war.

falak pema's picture

the noose gets tighter around the oligarchy as the old song of "thieves falling out" acquires a more ominous sound.

Between Mutti run Euroland and US/FED run global land, the ability to prime the oligarchy fiat pump is running out.

Soon the only money left to pilfer will be the wealth of the different CLANS of the Oligarchs.

Like in the Mongol Empire it will be every Horde for himself from then on. Or in the context of Roman civil wars, every legion for its leader.

Soon the cry will be "BaiL EM IN".

Offthebeach's picture

We are flooded with liquidity and credit.  Its unwanted, by and large.  Its trust thats short.  Know one knows in a hyper politicized,  asset price pumped economy what the mad theorist of the CBs will do next.

I think the carrot might be done and next the whip.  Enough of Lenins New Economic Policy, a Stalin will show the lazy dogs.  Invest, do or tax death!

LawsofPhysics's picture

"Meanwhile, other emerging markets are plodding along, which helps explain why markets as diverse as the Philippines (still recovering from the most powerful Typhoon ever recorded), Indonesia (feeling the brunt of China’s more muted coal demand), Pakistan, Sri Lanka or Vietnam are all up for the year. Even Thailand is flat year to date, despite a violent political crisis."-  Isn't Argentina's market also up dipshit?

Son of Captain Nemo's picture

Isn't Argentina's market also up dipshit?...

Yeah.  But won't she be attractive when agriculture (wine in particular) becomes too toxic in California, Oregon and Washington State!

So how many ex-executives from GE other than Immelt work for Obama's Administration?  Maybe GE will spearhead the effort to repopulate the planet when all of their Mark I reactors break down and spew radiation everywherein the Northern half?


chump666's picture

I have been following this for a couple of years now.  It seemed that the crisis was also going to be Asia/EM markets.  What is alarming, is the outflows and the lack of hedging or safe haven flows, are NOT going into US denominated assets.  It does look like o/s investors are pulling money as countries tightening capital controls, this is very much a prelude war trade.

Yelland/Bernanke/POMO and the FED suppression of risk aversion trades (gold), using the cronies of Wall Street to maintain the illusion of a supported market, will spectacularly blow up in their faces.  If the credit nations (Asia) collapse/implode the FED will lose control of everything.

q99x2's picture

Does that mean I won't be able to watch Revolution on Wednesdays?

chump666's picture

Unless the Patriots nuke your side of town.

Art imitates life.


Disenchanted's picture

So the Revolution is being televised?

Goddamit, another lie!

Carl Popper's picture


She is a cold hard bitch.

And she ain't leaving.

buzzsaw99's picture

The immaterial has become, immaterial. [/Lord Cutler Beckett]

ebworthen's picture

Gold and the end of the Dollar as the reserve currency can help end the hegemony the FED.

Just recall the chart of the progression of reserve currencies in the past 650 years:

outofideas's picture

Because the BOE doesn't still control the pound even after it stopped being the worlds reserve currency?

Carl Popper's picture

Didja notice that the British could no longer afford an empire?


They dropped out of that empire thingy and resigned as globocop once they no longer had reserve status.  


That is good enough for me.  If we can't end the fed we can sure end their easy money financing of neocon adventurism. 

outofideas's picture

Sure, and when that happened, post WWII, they had rationing for how long? Are the Brits any better off then they were before?

Spungo's picture

wtf is this article talking about? The world needs dollars to trade? Why can't they use their own damn currencies? Are they not aware that you can buy Australian dollars in France or Japanese yen in Britain?

bluskyes's picture

People do not like being bombed, and shot by those who issue the dollars.

Carpenter1's picture

So.....print MOAR??!?!

 Nah, my pig farmer understanding of economics tells me we need to start trading pigs for eggs, milk for wheat, and ditch the promises at the bar made by slick city guys who have nothing but words to offer.

realWhiteNight123129's picture

What Gavekal ignores is that a currency is a mean to an end. The USD is a dumb circulation medium, not an end in itself, the end is the circulation of goods and services. 


In other words the end is circulation of goods and services, people have been using seashells, fossils, tally sticks, Gold and Silver (better properties), toilet paper (USD). If the USD is unavailable is the world trade going to stop? This is ridiculous, people will find Yuan, Bitcoins, Gold, bilateral trade agreements, what have you. USD is only a circulation medium, and if necesary the mean can be dropped for a more convenient circulation medium, SDR, whatever will do as circulation medium.


The USD happens to be a circulating medium, if a Brazilian has soybeans to sell and a Chinese has manufacturing equipment to sell, if there is no dollar available, they will use something else.


The reason Asia is doing better vis a vis the taper is partly due to the fact that South-Asia already has a tight remittance system in Yuan, so they have more options. In Cakmbodia you can use Yuan bank remittance and transfers or dollars. 


As for the quality of a fiat money, it depends on the asset backing it (TSY and Mortgage bank securities).

In the old days Currencies from BoE were backed by Gold and good bills.

Of course if the economy of the US booms so much as to make the tax receipts great and income rise so much as to sustain the value of MBS than the US dollar will be good. 

However given the lack of capex as % of GDP going in a declining trend in the last couple of decades, how is the income of Americans going to rise dramatically to make the tax receipts of the US great and the affordability of homes soar?



Eeyores Enigma's picture

The amount of USD (not to mention other currencies) in circulation is an order of magnitude larger than the circulation of goods and services they are supposedly representing.

The vast majority of transactions around the globe are money for money.

Money does not represent a slice of the pie, more like it represents multiple claims of the same slice of pie.

This is essentially the issue as economics is supposed to be an accounting of pie slices and applying a $ value there-on. We are so far beyond that it is not even funny and yes if this ponzi shuffle is exposed or disrupted in any way Global trade will screach to a halt.

But first we have the great global scramble for PIE SLICES!

Anusocracy's picture

I worked for a short time on a Soviet made, German owned freighter. The Soviets used it to pay for German goods.

All that matters to the market is that both parties agree on the cost.

JR's picture

Austrian School Economist Hans Hoppe has always said that “the central bank functions as a last resort counterfeiter.” Which is true, what it deals in -  a Federal Reserve Note fiat currency - is counterfeit; it has no relationship to value; it only has relationship to what the private Fed cartel says is its value.

Globalization, i.e., monopoly, has replaced free-trade capitalism. And the failed world central planner is the Fed. Stalin and Mao Zedong failed in their attempts to create a World Socialist Market. It now appears that the International Bankers' internationalism of the economy, i.e., Globalization, is failing both on the commercial and financial level.

Based on socialism and global exploitation, its problems now are too big for the Fed to handle. With the current rapidity of dire happenings around the globe, I believe we’re seeing the last vestiges of these tyrants after all these years, all these countries, all these transfers of wealth…of poverty by design, all these lies contrived for starting wars…  And, now, it’s come to trying to muzzle the people of the United States, to controlling the most important nation that was ever conceived on God’s earth, via a banker-controlled media, a  banker-controlled Hollywood and a State-controlled educational system.

And the International bankers can’t handle it. Their system, like Mao’s and Stalin’s, is failing: the American people have no confidence in them, in their bought Congressmen and government, in their White House operatives.

We’re headed for the people to draw a line and say: You’ve crossed it.

Lew Rockwell and Hans Hoppe shed some light on the Fed:

Lew Rockwell: And so the Federal Reserve was to be the lender of last resort, in case any bank had any trouble. They wouldn't have to worry: they would get the cash from Washington DC.

Hans Hoppe: The question is, however, whether it really is desirable to have such a thing as a lender of last resort. The correct position appears to me that every single bank should be responsible for its own debts and contractual obligations, and if banks through imprudent policy then go bankrupt, this should not be considered a bad thing, but in fact considered to be a magnificent thing, because bankruptcies or the danger of bankruptcies is precisely what makes banks adhere to sound policies.

Lew sums up the Fed: It's really no different from a burglar in your house wanting to steal your money. That's what the Federal Reserve does. It depreciates your savings; it takes away your economic security; and it ought to be treated as an institution that does that, rather than something of alleged benefit.

akak's picture

My head is spinning after reading this crypto-Keynesian, neo-mercantilist goobledygook.

I thought mercantilism had been discredited as not just a zero-zero, but as an actual negative sum game, by all reputable (free-market) economists, oh, more than a century ago.

q99x2's picture

Bitcoin is my world's reserve currency. Open source software is my government. 

williambanzai7's picture

You have seen False Flag, now introooooduuuuucing Faaaaaaaaaallllllllllllse Price!

Racer's picture

We should all invest in:

“the United Metropolitan Improved Hot Muffin and Crumpet Baking and Punctual Delivery Company.”
shinobi-7's picture

There are more economic facts in this article than in a week of daily news coverage! It also shows clearly that once you "create" imbalances, they do not correct themselves. It takes immense political courage to work out a solution which of course is usually absent. So finally the system blows in slow motion like the circles of hell, from the periphery to the center. Investors try to understand which explosion matters more than the others, but in a global system the answer is none, the next one is always more frightening until the contradictions of the system are laid bare for everyone to see. I expect 2014 to be an extraordinary year in this respect and 2015 to be even more "interesting". Eventually, it will be time for Japan, China, Europe and finally the US to face the consequences of past decisions. We all know it. Well, not in 2014 is the current mantra. Let's hope not: Imbalances can grow tall indeed but eventually since nobody will do anything about them, it must all fall down to earth. It's just gravity.

From this corner of the earth, in Japan, what I have in plain sight is the "real" numbers of the country and what they tell me is that Japan is about half as rich as the official numbers say. So yes, it can last a little longer but eventually the two numbers will have to square. The Potemkin facade that Tokyo offers will soon cavitate under the dead weight of the rest of the country. Outside Tokyo the country looks more and more like Disneyland, well, the haunted part of it and the demons won't sleep forever.

JR's picture

An extraordinary and graphic analysis.

Bill Buckler called it the ‘art of the impossible’ – “the last gasp of a politico economic regime.”

Buckler, who wrote his final edition of The Privateer in May of 2013, used Japan’s welfare dilemma to describe "the current near pre-collapse state of the entire developed world" as “taking it to the limit.”  

He wrote in October of 2010:  

“In all so-called ‘developed’ nations, the welfare state is the mechanism which makes government depredations acceptable to the public. To establish and enhance the power of government, an ever larger portion of wages and salaries are sequestered through taxation and an avalanche of rules and regulations are enforced via government fees and charges. Some ‘compensation’ must be found to make this bitter financial medicine go down without becoming dangerously unpalatable. This is where the welfare state comes in. The only way to ease a situation in which it is difficult, to the verge of being impossible, for an individual to take care of him or herself is to create a situation where the State takes over the role. Or at least the State promises to take over the role, should it become ‘necessary’.

“This mechanism can ‘work’ - for a while - but the result is that there are more people dependent on the State than there are people who are able to create the wealth on which the State depends. This situation is inherent in all welfare states, approaching in most of them, and already here in one. That state is Japan.

Continued Buckler in 2010: [M]ore than half (56 percent) of Japanese workers rely on financial support from their parents or other sources to cover their living expenses. These are the same people who will, in future, be expected to perpetuate the ever more bloated Japanese welfare state. This stark and obvious impossibility is the current situation in Japan. It will soon be the situation right across the developed world. The ‘solution’ will be a rapidly increasing sell-off of rapidly diminishing ‘assets’. Most of these assets will be paper claims to wealth which does not exist and never did.

shinobi-7's picture

Thank you for the insight. I was not aware of this but arrived to the same conclusion. But with little merit since I saw what happened in Europe earlier. What is interesting about Japan is that the process was so much faster and therefore more obvious to understand,

"Most of these assets will be paper claims to wealth which does not exist and never did."

Yes, this is exactly what we are talking about. The trick for financial authorities is to paper over this fact. Then at some stage it becomes impossible and the system comes crashing down. If the crash is partial, you fill in the gap but if it is beyond a certain level, it becomes systemic and you have a general failure. We came very, very close to one in 2008. I suspect it will happen again soon but the triger, by definition will not be the same. (If it is the same, they will know what to do and will not let a major financial company go under whatever the cost.)





Cashcollateral's picture

Well this article was complete garbage.

1) "Capital" is not destroyed in a crash. It just moves out of the stockmarket and into something else. Normally cash. If you feel like your capital has been destroyed, you should talk to the guy who profited selling his stocks to you in the first place before the collapse to see where it went.

2) A weak dollar IMPROVES the value of overseas investments. Because the overseas investment is earning in a foreign currency? Which is worth more because the dollar is so weak?

Weak currencies have their own set of problems, but I don't think encouraging US exports and onshore manufacturing (and jobs) has ever been one of them.

3) True that the substantial trade deficit is what has kept the rest of the world awash in USD to trade amongst ourselves. Not true that running a smaller deficit will somehow destroy international trade as we know it. You'd need the US to run a massive trade surplus for 20 odd years before you could drain enough USD out of global circulation to damage international trade. And even then, we'd just borrow it from onshore in the US to finance the trade. 

Smaller Fed reserves would be a good thing in context of funding international trade because it would imply dollars going into the system. They're called "reserves" because they're not in circulation.

4) Someone already mentioned in the comments that countries can trade in a currency that isn't USD: in fact, they can trade in basicaly any currency. Which they can, and will, if borrowing USD or obtaining USD becomes too difficult. It's a naively Americocentric view that thinks the world stops because the US stopped handing out USD for a day. 

TL;DR: This piece is full of ignorance and logical fallacies. Who the fuck is this retard and what kind of poor, misguided imbecile would let him touch their money?

Youri Carma's picture
Very insightful piece. The U.S. has put QE into toxic assetest, huge amount of awry gone bets of the banking system, keeping up the DOW and Gold low.   China has put it's QE more in production which is not needed. China is slow in adapting to new circumstances which so often shows in over production which is form of capital misallocation.   China is concerned about it's citizens discontent while the West is only interested in keeping up a failed banking system at all cost. But this has destroyed the economy and thus China exports.