Januarys market turmoil has very little to do with
China but a lot to do with the U.S. The trigger? U.S. interest
rates. The dollar is considered a safe haven and is widely
expected to rise further. Yet the currency is in a bubble and
may soon fall. The signal of when dollar weakness will start
will come from China.
We have in front of us an example of one of the most
interesting features of modern finance. Market participants
have different models of reality to explain events. When mass
adherence to a model switches, it can cause sudden market moves
crisis even. The dynamics of such a change in beliefs
have driven some of the largest moves ever in asset prices. A
key in guessing possible futures is to know what the different
views are and who holds them: mapping the structure of investor
bases but also the beliefs of different investor types.
There are two major global structural problems:
overindebtedness in the developed world and imbalances in the
international monetary system. These issues were at the root of
the 2008 financial crisis, and they have not yet been fixed.
The second problem helped cause the first: Asian savings pushed
down the U.S. yield curve and encouraged excessive borrowing.
This, on top of lax regulation, led to the 2008 crisis.
Because government intervention was not sufficient, the
Federal Reserve saw itself as the only institution between the
U.S. economy and full-on depression. A radical, untried program
quantitative easing was instigated to provide
liquidity to banks and push up asset prices so that banks could
recapitalize themselves. This action was taken to avoid
depression. But to admit as such may itself have caused
uncertainty and risked a depression. So central banks have made
a distinction between maximum and optimal transparency. They
are misleading markets deliberately. Markets havent fully
understood this yet.
One result of QE has been the large inventory cycle in the
U.S. Optimistic firms stock up, only to be disappointed. Hence,
we have seen a repeated pattern of healthy growth for a quarter
or two, followed by near-zero the next. The data do not
indicate strong U.S. recovery yet, although the judicious
choice of base time periods continues to fool many.
Quantitative easing may have prevented depression, but it did
not stimulate the U.S. economy. Consumer prices have remained
The enormous liquidity that is quantitative easing has,
however, inflated asset prices, principally in developed
markets and the dollar. Central banks that havent been
injecting liquidity such as those in emerging markets
have seen their currencies fall versus the dollar, but
not because of any sense of crisis.
The International Monetary Fund was warning of excessive
dollar strength and the risk of renewed recession, should the
Federal Reserve raise interest rates. The Fed, however, in
December had no more excuses not to raise rates. The turmoil we
are now seeing was triggered by investors starting to doubt
their previous faith in the U.S. recovery.
What happens next? The renminbi had been pegged to the
dollar and so had been appreciating. Its depegging was not
motivated by trade competitiveness but so as to prepare the
renminbi as an alternative reserve currency. Yes, there was an
exit of money when the peg went in August. That was always
going to happen, given the very high money supply in the
Chinese economy a side effect of the post-2008 credit
boom. Limited choice in financial instruments, as well as a
homogenous investor base structure and beliefs, has further
added to short-term volatility.
The last time there were major imbalances in the
international monetary system was in the 1960s. The U.S.
amassed liabilities that significantly exceeded the amount of
gold backing the greenback under the Bretton Woods system. The
creditor countries at the time in Western Europe
lost patience with the U.S. in 1971 and then-president Richard
Nixon was forced to abandon gold convertibility. What came to
be known in economic history as the
Nixon shock has been painted as a U.S. choice, but it
wasnt much of one. Nixon could have decided to come off
the gold standard and keep the countrys gold stock or be
forced off the standard once all the gold had gone. The dollar
fell from $35 an ounce after reaching a brief low of $194 an
ounce in 1974. Chaos, and a decade of inflation then
Fortunately, today, with the U.S. as the main debtor again
but emerging markets the main creditors, a more gradual
adjustment in the international monetary system is possible,
indeed likely. Emerging-markets central banks and other
creditors do not want to be last to ditch depreciating dollars,
but neither do they want to be first, damaging short-term trade
competitiveness. Hence, they are motivated to follow
Chinas lead. Once Chinas currency market has
steadied in the coming weeks or months, we should expect, maybe
after a brief pause, the
renminbis reserve currency status to build, and
widespread appreciation of EM currencies against the
Jerome Booth is the co-founder of emerging-markets
investment management firm Ashmore
Group and, following his retirement in 2013, continues to
invest via his London-based private office, New Sparta Asset
Management . He is also the author of Emerging Markets
in an Upside Down World: Challenging Perceptions in Asset
Allocation and Investment , published in 2014.