Rising Dollar is Making the World Holler

The U.S. Federal Reserve drastically cut interest rates for over a decade to weaken the U.S. dollar exchange rate in order to make American exports more competitive and foreign imports more expensive.  Cheap money and a depreciating currency incentivized emerging market companies to borrow 9.3 trillion in U.S. dollars.  But with the Fed eliminating quantitative easing and other stimulus, the exchange rate of the U.S. dollar is strengthening, and the cost for foreigners to pay back “dollar loans” is rising.  Strong dollar periods in the 1980s and 1990s caused emerging market financial crises.  With the dollar appreciating, trillions in emerging market “dollar loans” may default.

From 2002 to 2012, the exchange rate of the U.S. dollar steadily declined by 38% as huge swaths of the domestic American economy were outsourced to contract manufacturers predominantly in China and other emerging markets.  Despite the Fed’s $5 trillion of bank liquidity offered at historically cheap interest rates, U.S. industrial loan demand tanked, and then real estate lending collapsed once the 2008 financial crisis hit.  

But with foreign companies desperate for cash and willing to pay high interest rates to fund a ramp-up of exports to the U.S., American banks, bond investors, and hedge funds loaned a record 2.3 trillion in dollars to foreign companies.  Taking advantage of the trillions of dollars of Fed liquidity sloshing around in global money markets, foreign banks and bond investors lent another $7 trillion in “dollar loans” to foreign companies.  At $9.3 trillion, foreign dollar loans exceed the entire GDP of China.  

Because foreign borrowers assumed that the United States' competitiveness would continue to be crushed by cheap emerging market labor, they also expected to book a future profit when they paid off their loans with depreciated U.S. dollars.

But with the U.S. energy boom stimulating American economic competitiveness, the U.S. dollar has strengthened by 13% over the last two years, and the Fed has reduced its economic stimulus.  The stronger dollar means foreign companies, mostly in Asia, now owe another $1.2 trillion in U.S. dollars on top of the $9.3 trillion they borrowed!

Hyun Song Shin, as head of economic research at the Bank for International Settlements, worries that past periods of U.S. dollar appreciation made emerging market “borrowers less credit worthy and dollar flows reversed,” causing financial crises.

The U.S. dollar appreciating by 51% in the early 1980s sparked the Latin American Debt Crisis.  Mexico and most of South America were forced to default on about $327 billion in “dollar loans.”  U.S.-based Citibank almost filed for bankruptcy, and virtually every major U.S. bank became insolvent.  The U.S. Treasury and IMF bailed out the Latin nations, and the American banks suffered a $67-billion loss.

With their economies growing by 8 to 12% of GDP per year in the 1990s, almost half of the total capital inflow during the decade went into East Asian developing countries.  Foreign debt-to-GDP ratios in U.S. dollars rose from 100% to 180%.  But as the dollar strengthened by 35%, Thailand, the Philippines, Indonesia, Malaysia, and South Korea defaulted on almost $500 billion in debt.  The IMF and World Bank had to provide over $100 billion in loans to restructure the debt.

Deflation is taking off in China and Asia as falling oil prices and shrinking access to dollar loans are causing “factory gate prices” to fall in China, Korea, Thailand, the Philippines, Taiwan, and Singapore.  Ambrose Evans-Pritchard of the London Telegraph reported that of 82% of items in the “producer basket” that includes machinery, telecommunications, electrical equipment, and commodities are deflating in China, 90% in Thailand, and 97% in Singapore.

Morgan Stanley warns that deflationary forces are “getting entrenched” across much of Asia.  MS worries that access to cheap dollar loans funded by the Federal Reserve caused the debt ratios in the region to jump from 147% to an unsustainable 207% of GDP in just the last six years.  The appreciating U.S. dollar and deflating sales prices mean that Asian borrowers are getting squeezed from higher debt and lower revenue.

All of this stress is related to only a 13% rise in the value of the dollar.  But if the U.S. dollar appreciates by the 35% to 51%, China and the emerging markets are headed for an epic financial crisis.

The U.S. Federal Reserve drastically cut interest rates for over a decade to weaken the U.S. dollar exchange rate in order to make American exports more competitive and foreign imports more expensive.  Cheap money and a depreciating currency incentivized emerging market companies to borrow 9.3 trillion in U.S. dollars.  But with the Fed eliminating quantitative easing and other stimulus, the exchange rate of the U.S. dollar is strengthening, and the cost for foreigners to pay back “dollar loans” is rising.  Strong dollar periods in the 1980s and 1990s caused emerging market financial crises.  With the dollar appreciating, trillions in emerging market “dollar loans” may default.

From 2002 to 2012, the exchange rate of the U.S. dollar steadily declined by 38% as huge swaths of the domestic American economy were outsourced to contract manufacturers predominantly in China and other emerging markets.  Despite the Fed’s $5 trillion of bank liquidity offered at historically cheap interest rates, U.S. industrial loan demand tanked, and then real estate lending collapsed once the 2008 financial crisis hit.  

But with foreign companies desperate for cash and willing to pay high interest rates to fund a ramp-up of exports to the U.S., American banks, bond investors, and hedge funds loaned a record 2.3 trillion in dollars to foreign companies.  Taking advantage of the trillions of dollars of Fed liquidity sloshing around in global money markets, foreign banks and bond investors lent another $7 trillion in “dollar loans” to foreign companies.  At $9.3 trillion, foreign dollar loans exceed the entire GDP of China.  

Because foreign borrowers assumed that the United States' competitiveness would continue to be crushed by cheap emerging market labor, they also expected to book a future profit when they paid off their loans with depreciated U.S. dollars.

But with the U.S. energy boom stimulating American economic competitiveness, the U.S. dollar has strengthened by 13% over the last two years, and the Fed has reduced its economic stimulus.  The stronger dollar means foreign companies, mostly in Asia, now owe another $1.2 trillion in U.S. dollars on top of the $9.3 trillion they borrowed!

Hyun Song Shin, as head of economic research at the Bank for International Settlements, worries that past periods of U.S. dollar appreciation made emerging market “borrowers less credit worthy and dollar flows reversed,” causing financial crises.

The U.S. dollar appreciating by 51% in the early 1980s sparked the Latin American Debt Crisis.  Mexico and most of South America were forced to default on about $327 billion in “dollar loans.”  U.S.-based Citibank almost filed for bankruptcy, and virtually every major U.S. bank became insolvent.  The U.S. Treasury and IMF bailed out the Latin nations, and the American banks suffered a $67-billion loss.

With their economies growing by 8 to 12% of GDP per year in the 1990s, almost half of the total capital inflow during the decade went into East Asian developing countries.  Foreign debt-to-GDP ratios in U.S. dollars rose from 100% to 180%.  But as the dollar strengthened by 35%, Thailand, the Philippines, Indonesia, Malaysia, and South Korea defaulted on almost $500 billion in debt.  The IMF and World Bank had to provide over $100 billion in loans to restructure the debt.

Deflation is taking off in China and Asia as falling oil prices and shrinking access to dollar loans are causing “factory gate prices” to fall in China, Korea, Thailand, the Philippines, Taiwan, and Singapore.  Ambrose Evans-Pritchard of the London Telegraph reported that of 82% of items in the “producer basket” that includes machinery, telecommunications, electrical equipment, and commodities are deflating in China, 90% in Thailand, and 97% in Singapore.

Morgan Stanley warns that deflationary forces are “getting entrenched” across much of Asia.  MS worries that access to cheap dollar loans funded by the Federal Reserve caused the debt ratios in the region to jump from 147% to an unsustainable 207% of GDP in just the last six years.  The appreciating U.S. dollar and deflating sales prices mean that Asian borrowers are getting squeezed from higher debt and lower revenue.

All of this stress is related to only a 13% rise in the value of the dollar.  But if the U.S. dollar appreciates by the 35% to 51%, China and the emerging markets are headed for an epic financial crisis.