The first sign of trouble occurred earlier in August when the Turkish lira sank heavily and all eyes shifted to trade and capital flows in the emerging markets (EM). Fears mounted that other EMs, such as Brazil, India, Indonesia, and Russia would experience significant currency devaluations that would set off a chain reaction that would hit the currency and credit markets in the advanced nations. So far, we have witnessed a currency crisis familiar from the past. The Chinese yuan is off nearly 10% from the highs of the year as the Chinese authorities manage their response to the Trump-lead trade war. The Brazilian real is down by 18% (YTD), the Russian ruble by 20% (YTD), the Indian rupee by 10% (YTD), and the Pakistan rupee by 17%(YTD), necessitating a call to the IMF for help.

Despite these major currency re-alignments, the EMs’ trade performance is clearly heading in the wrong direction (Figure 1). Both nominal exports and imports have been on a downward slope since the beginning of the year and are in negative territory today; volumes have also contracted. Some of the reasons for this poor trade performance can be traced to a drop in major commodities (e.g. copper), a rise in trade barriers and continued underperformance in many advanced countries (e.g. EU, U.K. and Japan).

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Figure 1 EM trade Performance 2015-18

A nation cannot tolerate a decline in its trade performance and simultaneously an outflow of capital for long before its economy becomes unstable, ultimately, leading to full-blown currency and credit market crisis, such as we are seeing today in Turkey and Venezuela. Both debt and equity markets saw portfolio outflows, led by Asia with an $8 billion drop and Africa and the Middle East with a $4.7 billion outflow in May, alone. (Figure 2).

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Figure 2 EM Capital Flows

As the Institute for International Finance reports:

No single driver of outflows from EM assets stands out. Instead, a combination of factors appears to be at work: idiosyncratic domestic strains such as funding pressures in Argentina... and renewed U.S. tariff threats and retaliatory actions; and political uncertainty in Italy and Spain…  and the risk of upward pressure on the USD—in response to rising U.S. interest rates.

Worldwide, US dollar liquidity¹ is declining and this creates a major headache for the EMs that have large current account deficits and high levels of US dollar-denominated debt. Furthermore, matters get worse every day as their currencies fall versus the US dollar. While Turkey, Brazil, and Venezuela are in the headlines today, we can expect other EMs with similar balance of payments conditions to become the next focal center. The real brunt of the crisis will be borne by those banks that have large exposure to the EMs. The U.K. banks are very high on that list, followed by several European continental banks. At least one EM central bank has come out publicly citing the stress on so many nations due to the Fed withdrawing liquidity. It is reported that India’s central bank governor wrote to the Fed to urge the Federal Reserve to slow the pace at which it plans to shrink its balance sheet to help ease the current market turmoil. Other major central banks have come out in favor of “normalizing” rates and reducing their bloated balance sheets. Both developments will force investors to reassess their risks going forward in many EMs.

¹ Liquidity Tightens Just As The World Needs More Dollars