A week after Sir Auric gives the heads up on FX, Barron's weighs in: "World of Woe
How long can the U.S. remain in sunshine as a global storm
brews?
By William Pesek Jr.
Tucked in almost every speech that Lawrence Summers makes is a warning
about possible dustups in the global economy and how they could put
America's prosperity at risk. Until recently, the Treasury Secretary seemed
like a bit of a worrywart, given how economies in Asia and Latin America
snapped back from the crises of 1997 and 1998. More recently, however,
Summers sounds prescient as another emerging-market crisis appears to be
developing, albeit off the radar screen of most investors.
From Manila to Buenos Aires, policy makers are struggling to get a handle on
financial problems with the potential to send shock waves through their
regions and beyond. Turmoil in currency and debt markets in Thailand, the
Philippines, Indonesia and Korea not only is reviving worries about a new
meltdown but is imperiling economies that had avoided the problems of recent
years. Taiwan, New Zealand, Australia and South Africa, for example, may
not be immune this time. In Latin America, turmoil in Argentina is spooking
investors who fear a new bout of financial contagion.
Can the U.S. avoid being dragged into
the mess if things worsen, as it did so
successfully in 1997 and 1998? Yes,
but not as cleanly. "Where's the money
going to go? Not into Europe, where
the euro is plunging, or the weak
Japanese economy," observes Carl
Weinberg of High Frequency
Economics. "The U.S. may not get the
same boost it did from the crises of
recent years, but it will still be the safe
haven of choice."
During the 1997 Asian meltdown and broader emerging-market crisis a year
later, the U.S. actually benefited as capital coursed into dollar-denominated
assets. As the Federal Reserve pumped liquidity to stave off the crisis it saw
in the global financial system, U.S. interest rates plunged and stock prices
soared. While the manufacturing sector suffered slightly, that was more than
offset by growth in other sectors, notably high tech, fueled by the explosion in
money and credit growth. Meanwhile, American businesses and consumers
garnered a windfall of cheap imported goods from highly leveraged foreign
producers. In hindsight, the 1997-98 global financial crisis was a win-win
situation for the U.S.
But this time around, America may not be so lucky. The economy is slowing
under the weight of six Fed rate hikes since mid-1999, while volatile equity
markets have stopped fattening household wealth. At the same time, the
nation never has been so dependent on foreign capital to cover its massive
current-account deficit and to make up for the paucity of personal and
corporate savings. And now, toss in the specter of a political crisis.
To be sure, there are reasons to think the U.S. is even less vulnerable today
to the sort of scenario that played out in 1997-98, argues Kenneth Kim, an
economist who follows emerging markets for Stone & McCarthy Research
Associates. For one thing, there's far less leverage in the financial system.
Russia's currency devaluation and bond default two years ago caught hedge
funds in over their heads, prompting Wall Street giants to bail out Long-Term
Capital Management. Now many of the other big macro hedge funds have
folded their tents.
But another crisis would be problematic for the U.S. One reason is the nature
of the global mess that some observers think is unfolding. Asia's break in
1997 and Russia's collapse in 1998 were largely economic events. Investors
who'd rushed into Asian, Latin American and European emerging markets left
faster than they'd entered as currencies fell, debt levels rose and recession
loomed. And markets and economies rebounded impressively once policy
makers implemented reform programs.
But today's bout of market turmoil has an additional source: political
instability.
These concerns are worsening the effect of economic problems -- such as
fragile banking systems and high foreign debt levels -- that already exist. In the
Philippines, opponents of President Joseph Estrada are calling for his
impeachment. In Taiwan, foes of President Chen Shui-bian are seeking new
elections. In the Americas, Argentina is struggling with a weakened
government coalition on top of a stubborn recession and speculation that it
soon will abandon its currency peg to the U.S. dollar. If Argentina goes, it
could take Brazil -- a much larger economy -- along for the ride. And in Peru
and Mexico, meanwhile, there's considerable uncertainty over transitions from
one leader to another.
Investors never like political instability, but nowadays it poses risks to badly
needed economic reforms. During the 1997 and 1998 crises, leaders rushed
to implement confidence-boosting changes like strengthening banks, opening
markets and improving transparency. But as soon as money returned to Asia
and Latin America, there was less urgency for reforms. Political uncertainty
may only exacerbate investor fears about economies moving in the opposite
direction.
All of this hasn't escaped the credit-rating agencies. Standard & Poor's
recently downgraded Peru's sovereign debt rating. It's also reviewing
Argentina's economic prospects, prompting fears that a downgrade may be
forthcoming. S&P last month took a similar step in the Philippines, revising its
credit outlook from Stable to Negative. What rating agencies are
acknowledging, says Chen Zhao of the Bank Credit Analyst, is that "any
number of things could push Asia into another economic contraction." He also
says recent signs of panic in Taiwan's markets are frighteningly similar to
Southeast Asia's experience in 1997. "Taiwan could be the last gasp of the
Asian equity bubble," he adds.
Surging oil prices exacerbate both economic and political risks for
emerging-market economies, of which Summers is acutely aware. For a big,
rich economy like Japan or Germany, higher gasoline prices are a problem.
But for a developing economy with a weakening currency, rising energy costs
can be disastrous. Consider Brazil: the price of its main export, coffee, has
plunged, while the cost of its main import, oil, has soared.
Prior to the recent turmoil, however, emerging-market bonds had been strong
performers. The yields of emerging market bonds relative to those of
benchmark U.S. Treasuries have fallen sharply. And lower yields translate
into higher bond prices. J.P. Morgan's global emerging markets bond index
may have dropped 2.03% in October, but the year-to-date total return on
debt is 10.01%. But emerging debt has hit a wall along with high-yield U.S.
corporate bond markets in the U.S., underscoring the risks of a global
contagion. In such an environment, some investors are avoiding
emerging-market debt at all costs. According to Morningstar.com,
emerging-market bond funds have offered a total return of 12.55% over the
last 12 months. But in the past three months alone, they've lost 4.43% --
1.90% in the past week alone.
For investors in top-performing mutual funds in this sector -- such as the
GMO Emerging Country Debt funds, which are up 27% over the last 12
months -- these recent losses seem bearable. But few can forget the
emerging-market meltdown in 1998 and, against that backdrop, many
investors are even opting to instead buy risky U.S. high-yield bonds. That's
because recent history shows that in times of turmoil, American junk debt gets
hit, but emerging-market bonds bear the brunt of global selling. "From a value
and liquidity standpoint, I would rather be in U.S. high-yield debt," says
Loomis Sayles' Dan Fuss, one of the world's biggest bond-fund managers.
Indeed, liquidity is becoming a problem for the emerging markets. Consider
Argentina's sloppy attempt to sell debt last week. While the big South
American nation managed to peddle some $1.1 billion of short-term debt, it
had to offer sky-high interest rates. Borrowing has become so difficult for
Argentina that markets are speculating that the government soon will turn to
the International Monetary Fund for help. Its borrowing needs next year are
pegged at $19.5 billion. Argentina has a currency board, which keeps its peso
equal to $1. But maintaining this currency regime, which is a ready scapegoat
for a contracting economy and high unemployment, is ultimately a political
decision.
Aside from the Argentine peso, a frightening number of currencies are on the
defensive nowadays. The South African rand recently fell to a record low
against the greenback, as did the Philippine peso. The Thai baht is at a
28-month low versus the dollar, returning to levels seen during the Asian
financial crisis. Singapore's dollar has been sliding, as have the Brazilian real,
the Korean won and the Chilean peso. Brady bonds -- which are
denominated in U.S. dollars but ultimately depend on the health of the
economy of the issuing country -- also have experienced heavy selling.
It's not surprising, then, that some are wondering whether a new
emerging-market crisis is afoot. So far, there are few telltale signs of the kinds
of contagion that infected markets in 1997 and 1998. Yet the
across-the-board weakness of so many currencies outside the U.S., Japan
and Western Europe deserves attention.
The J.P. Morgan Emerging Markets Bond Index Plus (EMBI), which
compares developing-economy yields over comparable U.S. Treasuries,
widened to 7.84 percentage points last Thursday from 6.77 at the end of
September. Spreads are nowhere near levels reached at the height of the
Russia-related turmoil that slammed markets around the world. At the end of
August 1998, the EMBI spread was 1,524 basis points. But the recent
weakening in emerging-markets indicates, at the very least, that the recovery
from the crisis of two years ago has run its course; at worst, a new crisis may
be brewing.
Even the IMF thinks investors may be more cautious in the current quarter
amid worries about global earnings growth, higher oil prices and currency
instability. A new IMF report put special emphasis on the narrowing of
spreads between yields of emerging-market debt and U.S. junk bonds. The
yield gap between the two asset classes is now the narrowest since October
1997; in other words, the market sees the condition of speculative-grade U.S.
corporations to be as parlous as that of these emerging economies.
Ironically, U.S. markets could be a catalyst of a crisis. As if emerging-market
economies didn't have enough problems, they've also fallen victim to recent
turmoil in U.S. high-yield markets. Investors looking to offset losses in junk
bonds trimmed their holdings of emerging-market debt, taking advantage of
double-digit returns to raise cash and reduce risk. Others, recalling all too well
the financial contagion that slammed more speculative markets, dumped
emerging-market bonds and moved to safer pastures. Also behind the selling
of U.S. corporate and junk debt was fear that slower economic growth and
earnings will hurt Wall Street.
"All of this is a reminder that the next financial drama might well have its roots
in the United States," says Rory Robertson, economist at Macquarie Bank.
Of course, the U.S. isn't the only industrialized economy of which investors
are wary. The euro, for example, is a major risk to the global financial system
because of the chaos it's causing in global currency markets. Japan's
economy, meanwhile, is barely expanding, and its efforts to add fiscal stimulus
have resulted in a crushing debt load. Emerging markets may have their own
problems, but they're also vulnerable to shocks from larger economies that
historically have featured stable conditions.
In the meantime, the U.S. may be a shelter from the storms brewing abroad.
But for how long?
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