For decades, the interplay between the United States’ economy and the rest of the globe has been a dance easy enough to follow. Emerging markets produce, America consumes. The U.S. dollar weakens, foreign currencies strengthen. The Federal Reserve prints money, foreign central banks build up reserves. Money flows from developed to emerging markets, and the dance is enjoyed by all.
But every once in a while the music of monetary policy changes, forcing America and the west to change their steps in line with the new beat. The change throws foreign dance partners off at first, as they stumble and trip all over themselves before getting their economies back in sync with America’s new routine. They must recalibrate almost every major aspect of their economies to America’s new monetary direction and pace.
Five years of U.S. monetary stimulus have begun to unwind, to be followed in a few quarters’ time with a slow and steady renormalization of interest rates. Where money had for so long flowed in one direction – from the west to emerging markets – the flow has turned in the opposite direction.
Their capital inflows drying up, emerging economies are scrambling to locate capital and regain their financial footing. The U.S. may be finally coming out of its credit crisis, but foreign markets may soon be faced with one of their own.
Yet if we scan a little more carefully across the global dance floor we just may spot some strong economies who haven’t missed a step among the crowd of stumblers. While the dance music has changed several times already, sure-footed South Korea, for one, is still dancing up a storm.
The Changing Music
Leading up to the 2008 financial crisis, America consumed and devoured goods and services insatiably, driving up the value of everything from consumer goods to commodities to homes to stocks. This inflated bubbles not just in domestic property and stock markets, but also in foreign markets which where supplying most of the consumer goods.
Emerging markets enjoyed unprecedented growth in GDP from 2004 to 2008:
• South Korea’s GDP rose from $722 billion to $1,049 billion for a rise of 45 percent
• India’s rose from $721 billion to $1,224 billion for a rise of 70 percent
• Turkey’s rose from $392 billion to $730 billion for a rise of 86 percent
• China’s rose from $1.9 trillion $4.5 trillion for a staggering rise of 137 percent
• These compare with America’s GDP growth from $11.8 trillion to $14.2 trillion, some 20 percent.
As the U.S. and Europe consumed, and emerging markets fed that consumption, money flowed from west to east, filling the coffers of emerging market central banks and inflating their currencies. While the Indian rupee appreciated by more than 15 percent, the Turkish lira grew 19.5 percent, the Chinese Yuan grew by more than 21 percent, and South Korea’s Won increased by more than 28 percent.
When the money ran out and credit evaporated, the band switched from a jazzy beat to the death march. Almost every country experienced GDP shrinkage over 2009 – except for China which grew by 10 percent – and almost every currency fell – except for the Chinese Yuan which remained peggedly stable. For their parts, the Indian rupee fell 24 percent, the Turkish lira fell 33 percent, while the South Korean won fell over 41 percent.
Money suddenly started flowing from east to west – from the harder-hit foreign markets to the safe haven of the USD and U.S. Treasuries. As money exited the emerging world, account deficits could not be paid for, and central banks began dipping into their reserves to cover their governments’ budget shortfalls.
All would have gone to hell if not for the historic response of the U.S. Federal Reserve to pump liquidity into the U.S. economy through bailouts, stimulus and ultra low interest rates. Money was flowing again, even if it had to be printed.
Round And Round We Go
With its wallet all fattened up, America resumed its spending and consumption. From 2009 to 2013, foreign market GDP began rising again and currencies were on the mend.
• Turkey’s GDP rose 28 percent and its lira rose 28 percent
• South Korea’s GDP rose 35 percent and its won rose 44 percent
• India’s GDP rose 50 percent and its rupee rose 18 percent
• China’s GDP rose 82 percent and its yuan rose 13 percent
Again money flowed from western nations to emerging. The only difference was that this second time around the dance floor, the flow wasn’t driven as much by western consumption as before. A larger portion of the money flow was due to ultra low interest rates in the U.S. and Europe.
Known as the “carry trade”, investors and institutions borrow money in countries where interest rates are low, and park that money in countries where interest rates are high, earning a profit between the interest earned at the one end and the interest paid at the other.
So while the Federal Reserve’s stimulus and low interest programs were designed primarily with America’s needs in mind, they ended up benefitting the whole world indirectly. Until now…
Now that the Fed has begun slowing the flow of stimulus in America, the USD has grown a little stronger. Bond yields and the cost of borrowing have begun rising, and have begun eroding the carry trade’s profitability.
Like in 2008, money is once again flowing out of emerging markets back to the safety of U.S. Treasuries, and the dance goes round and round. Since early 2013, the Turkish lira has lost 21 percent, the Indian rupee has lost 11 percent, the Chinese yuan has lost just over 0.4 percent, and the South Koran won has lost – no, wait a minute – has gained 9 percent.
There is something different about South Korea. While the other dance partners are stumbling to regain their footing now that America has begun dancing a new step, South Korea seems to have not skipped a single beat this time. What is it doing right?
South Korea Keeps its Balance
While all countries realize the importance of increasing their income through exports, few discipline themselves enough to keep their expenses down. As a result, most nations run a current account deficit with annual budget shortfalls.
To cover that shortfall, countries need to borrow. It works out fine when other countries have money to lend, as in the carry trade activity prior to market crashes described above. But when those crashes occur and liquidity dries up, the lending stops. That’s when countries with current account deficits run into trouble, as they are forced to borrow at exorbitantly high interest rates or dip into their reserves, ruining the value of their currencies which feeds massive inflation.
This is what is happening to India and Turkey which have been running account deficits almost perpetually since their independence. The major part of the problem is their negative trade balance, as they import more than they export.
But South Korea has not fallen into the trap of relying on foreign deposits to finance its expenditures. It has disciplined itself to pay its own way. Since 1998, South Korea has enjoyed an almost perpetual current account surplus thanks in large part to an almost perpetual trade surplus.
So as the U.S. reduces its stimulus and even begins raising interest rates in a few quarters, South Korea isn’t concerned. Stimulus reduction in the west means those economies are recovering, increasing South Korea’s export potential all the more, with Bank of America Merrill Lynch forecasting 8 percent growth in exports to the US and EU in 2014.
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No Bubbles to Burst
South Korea has also managed to avoid asset bubbles. Because South Korea was not such a heavy borrower from other countries, it has managed to keep its interest rates down to between 2 and 3.25 percent since 2009. This meant it did not attract carry trade activity and did not experience the same infusion of capital that other emerging nations did.
While the infusion of capital into a developing nation through the carry trade helps it cover its account deficit, it has the adverse effect of inflating assets such as property, equity and bond markets, as all the money coming in is invested in homes, stocks and bonds. The more foreign money that enters through the carry trade, the more inflated those asset bubbles become. Once foreigners start pulling their money back out, all those bubbles burst and their markets come crashing down, setting those nations up for yet another financial crisis.
But since South Korea was not a primary destination of the carry trade, its markets have not overinflated. They have not corrected down with the reduction of stimulus in America, and they will likely be spared the next liquidity crisis that will almost assuredly befall emerging markets in 2014 – if it hasn’t begun already.
Investors looking to diversify some of their holdings outside of the U.S. and Europe should look carefully at the country’s dependence on foreign deposits. As the bond and equity markets in the west grow ever stronger and interest rates start rising, money will increasingly be parked in the west and will not be readily available to help developing nations finance their account deficits.
Nations like South Korea that have solid balance sheets with trade surpluses will be the ones who keep their balance and never miss a step as the music of monetary policy in the west changes. Dance with the likes of them and you won’t lose your toes.