An EM Debt Crisis Is Really A Dollar Crisis 2
How would an emerging market collapse come about?
Again using the mainstream narrative/paradigm as a starting point, such a collapse comes about from capital outflows. This is just a fancy way of saying that money will move out of one country and into another.
Common reasons for such outflows include political upheaval in a country, more often that not combined with its creditworthiness going out the window – hence higher rates.
Sometimes political upheaval causes plummeting creditworthiness, and sometimes plummeting creditworthiness causes political upheaval. More often than not it is hard to tell which came first, but regardless of how it starts, it always ends with the general population suffering immense hardship.
Good historical examples of these include the Asian Financial Crisis in 1997, as well as the European debt crisis that began sometime in 2009.
Of course, capital outflows can and do occur without such chaos. This happens regularly as investors re-allocate capital across different international markets in order to get the best possible returns on their capital.
For instance, an investor who owns US Treasuries which yield 2% might sell those and buy emerging market bonds, which yield, say 4%.
It is very important to note that because US rates are perceived as the global risk free rate, it is difficult (but not impossible) to find fixed income instruments that yield less than the equivalent maturity UST.
Consequently, capital outflows for the purpose of earning higher returns almost always happens in one direction – out of USTs.
However, capital can still flow into the United States to invest in other kinds of assets. These include, but are definitely not limited to, traditional financial assets like bonds and equities, as well as more niche financial products like venture capital.
Such inflows tend to occur when the US economy is growing at rates that are relatively higher than other economies, causing investors with an international reach to reallocate their cash in favor of these opportunities.
This is the concern that the head of the IMF is raising, that a relatively stronger US economy would pull capital away from emerging markets. This could cause a spike in emerging market rates due to concerns over their creditworthiness, as economic growth remains stagnant, negatively affecting businesses’ and the government’s ability to service their debts.
Of course, this sequence of events is built upon the assumption-masquerading-as-belief that the Great Reflation of 2021 is real.
Real in this case meaning the furious rally in yields is indicative of an economic recovery that is broad based and robust. Which is what is needed to create rising levels of aggregate demand and, from there, the “good kind” of inflation.
This is, in turn, predicated on the unwavering belief in the efficacy of monetary and fiscal policy.
The Fed’s trillions in QE and support to the financial system, together with Biden’s trillions in stimulus to households, businesses, and potentially infrastructure, is supposed to turbocharge the US economy to new economic (and inflationary) heights.
But, what if none of these beliefs are as absolute as the mainstream narrative makes them out to be?
To be continued…
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