Article / 30 January 2014 at 14:23 GMT

Russia a catalyst for EM and global troubles

Chief Economist & CIO / Saxo Bank

EM crisis unlikely to go away
Devaluation worries gather momentum
Hike in interest rates a disease

By Steen Jacobsen

After taking an express train to St Petersburg, I have just left behind Moscow and its minus 20-degree Celsius temperature. Russia is very much a part of emerging markets (EM) and, more importantly, one of the countries that is fast losing its economic momentum due to a lack of reform. As long as this is the case, the EM crisis is not going to go away. If anything, it will probably get worse before markets and currencies across EM find a new and probably much lower equilibrium?

Policy makers, sovereign governments and their not-so-independent central banks in EM are all seeking a rebalancing, which for the current account deficit countries (Fragile Five + Russia) means lower currencies to take a short-cut to more competitiveness. The problem with this approach is that there are no such short cuts, as these countries all failed to use their high-growth period to invest in long-term capital formation. Instead, they invited “franchise” capital during the boom years with open arms. Think burger joints, quick solutions and fast profits. But nowhere did this franchise model include increasing domestic competition and opening up. This now means that corruption and the misallocation of capital have accumulated for some countries over a full decade since the Berlin Wall came down 25 years ago. Time is simply running out.

Furthermore, this game of buying a “tail-wind” or short-term support for your economy by seeking lower currency rates removes all incentives to own EM at all. I recently discussed this subject and a related paper, written by my friend Jeppe Ladekarl and his colleague Edgar E. Peters in my last Steen’s Chronicle. My argument (theirs, indirectly) goes like this:

EM central banks and governments are now pursuing lower growth and weaker currencies to slow imports and increase exports, but by doing this they “penalise” EM investors, who will want to run for cover. EM investors , if invested in EM equities, makes 70 percent of the return through FX revaluation, and if in EM bonds, almost 100 percent of the returns are attributed to exchange rate changes. So when policy makers signal they will allow weaker currencies forward, then by definition the last place you want to invest is in EM. Voilà, the perfect vicious circle has been created.

Now, over the last few days, a degree of panic has ensued. The momentum of the devaluation is picking up and rates such as USD/RUB are almost as high as they were during the peak of the global financial crisis. The same applies to Turkey, Indonesia and South Africa. Their response?  Higher short-term interest rates, which of course hurt their bonds, their equity markets and, ultimately, also their currencies. The market has largely shrugged of the Central Bank of the Republic of Turkey's recent interest rate hike, and the same goes for the South African Reserve Bank's attempt to use rate hikes to restore some semblance of order. These macro solutions will increase the tensions as the hike in rates is a disease we have seen before: the 1992 ERM crisis and the 1997/98 Asian and Russian crisis. If you can't recall those days, please realise that during the ERM crisis in 1992, the Swedish kroner overnight rates went to 10.00 percent. Did that stop them from devaluing? Not at all! If anything, panic short-term money market hikes are a sign of weakness, not strength, and play into the hands of investors who are shorting EM.

Does this mean doom and gloom are coming ? Not necessarily. What we should realise is that this is the third wave of this crisis: the first wave was the US housing and bank crisis. This was followed by the crisis in European debt, and then we arrived, full circle to Asia and EM overall. As we move through these stages some assets get “ burned”, some merely survive while others thrive. Commodities, one of the traditional growth indicators, peaked in 2010/11, fixed-income finally tired in late 2012 and crashed and burned in 2013. Now, 2014 looks like a case of “sick” equities, which may begin to struggle from here and hit a secular low Q4-2014 or Q1-2015. Bonds, meanwhile, could have one last hurrah, with new lows in yields in the second half of 2014.

The conclusion here is that we have just started the final move in this crisis. However, the good news is the word “final” — the crisis for EM, Europe, the US and certainly Russia will create the necessary mandate for change. It seems we can only make the real changes when the previous paradigm has totally failed and we are in a moment of crisis. And globally, we have failed and are finally discovering that fact through this final crisis phase, not only in Russia or EM, but everywhere as we have failed with our macro policy mistakes to promote the real engine of the economy: the micro economy of small and medium enterprises.


The Berlin Wall came down 25 years ago this year. Alexia Bannister / iStock

This is happening in the 25th anniversary year of the Berlin Wall coming down. In the late summer of 1989 we were celebrating that market-based economies had won the battle with the planned economies. Isn’t it ironic that if we
fast-forward to today, we see the current dire need to break another wall down — the wall of bad central macro planning by central banks and sympathetic governments. We need to “go micro”, from big business to small business, from the state to individuals, and from state and central bank intervention to market-based pricing.

Russia is our catalyst. I remain a bull on Russia but only if we get a crisis. It looks as though that crisis is now almost guaranteed by the inaction and the lack of accountability of the world policy makers.

It may be a sign that the sun has just broken through the clouds as we pulled out of Moscow, it’s still minus-20 celsius outside, but this is easier to bear when the sun is shining.

Safe travels.


The Grinch The Grinch
The scramble for how it used to be has been striking. Not long now till everybody can pat each other on the back for a job well done and begin relishing the fruits of the next cycle. I don’t think trouble in the EM is going to change that. In my opinion, ‘real change’ is still some way away. Perhaps by the time of the next crises the appetite will be greater, as the ability of governments to intervene will be hampered by the hangover still lingering from the party just gone.
Having said that, I am intrigued by your suggestion that bonds may stage a comeback in the medium term as another twist to the financial crises unfolds. This is already happening, so your expectation of even lower yields during the second half of 2014 implies that you are seeing the EM turmoil getting worse, triggering an escalation in the flight for safety that will outweigh the effects of both tapering and economic recovery? In this scenario, do you see gold re-entering the stage as safe haven?


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