How to help EM economies following a tough 2016
Last week I wrote about how I believe the "Trump dollar" may be a temporary phenomenon and within months of his inauguration, the hype around Trump and his ability to turn the U.S. economy around, will have faded. Short of addressing income inequality, no solution to economic stagnation will be long-lasting. With the newly elected U.S. Congress, it appears unlikely that Trump will be able to pass any bills that would address income inequality. This will lead to social unrest in the United States as a result of an ever increasing gap between the rich and the poor. Whether or not it will take the form of an "occupy" type movement or something broader is yet to be seen. In any case, the "Trump dollar" won't last. My advice, however, for emerging market economies is, "don't' hold your breath" and take pro-active steps to insulate yourself against the effects of currency fluctuations in the future.The U.S. dollar plays a daily role in the lives of everyone the world over. I'm not talking about commodity prices, that's a much bigger problem, I'm talking about something more micro. I'm talking about changing a mindset. Currently in Turkey as in all other emerging markets, real estate transactions are widely conducted in U.S. dollars. So this means the pair of shoes you just bought that were manufactured domestically with domestic raw materials and labor has a U.S. dollar or perhaps euro component. Why?
During the weak dollar period of 2002-2008, the U.S. dollar depreciated against global currencies. Inflationary fiscal spending coupled with massive defense spending in fighting wars in Iraq and Afghanistan made the dollar weak and U.S. products and investments cheaper. Real estate investors looked elsewhere to make money, namely emerging markets. They borrowed dollars and euros, exchanged them for local currencies and made investments. They charged rent in these same "hard currencies." As the currencies declined, tenants paid less rent, they were happy, and landlords were able to repay their debt, so they didn't care. With the Great Recession, this cycle ended. The dollar trounced the euro and all other foreign currencies. In the shoe example, the cost of the shoes itself, raw materials and labor, is one component. The expense of selling the shoe, sales force labor and rent, is another.
In this example, if the local currency depreciates against the U.S. dollar, the price of the shoes, entirely made domestically, increases. This sets off inflationary pressure, which in turn causes interest rates to rise which slows economic development which decreases tax revenue. The vicious cycle never ends. Here's a suggested solution: The emerging market country in question, sells domestic currency futures against the U.S. dollar. It mandates that all rent be paid only in the local currency. It provides tax rebates to cover the cost of the purchase of these futures. This is net revenue neutral for the government and landlord so far. The price of the shoes will no longer change. Consumers will no longer need to horde dollars in the event of a currency crisis because the costs of the goods and services they consume will be priced in the local currency.
Now to offset the government's currency risk: The emerging market enters into swap facilities with countries that it conducts trade with. These countries need to be big enough so that this currency risk doesn't materially affect them. China is the main candidate here with the ECB and Russia coming in second and third. The Chinese swap Yuan for the domestic currency of the emerging market. It continues to sell goods and services to this country while taking on their currency risk. China's currency is practically pegged to the dollar and it enjoys billions of dollars in trade surpluses anyway and thus doesn't have difficulty financing dollars. The swap facility allows for the emerging market to pass on its currency risk while committing purchasing Yuan denominated goods which is great for China. Should the dollar appreciate, Chinese goods will only be cheaper for the American consumer resulting in more Chinese manufacturing and economic growth.
This appears to be a win-win-win-win model for all countries involved. Emerging market economies need to partner with export powerhouse nations for the mutual benefit of all. This simple tool may help in decreasing global income inequality as well and maybe this time next year, we will be singing the praises of 2017!
During the weak dollar period of 2002-2008, the U.S. dollar depreciated against global currencies. Inflationary fiscal spending coupled with massive defense spending in fighting wars in Iraq and Afghanistan made the dollar weak and U.S. products and investments cheaper. Real estate investors looked elsewhere to make money, namely emerging markets. They borrowed dollars and euros, exchanged them for local currencies and made investments. They charged rent in these same "hard currencies." As the currencies declined, tenants paid less rent, they were happy, and landlords were able to repay their debt, so they didn't care. With the Great Recession, this cycle ended. The dollar trounced the euro and all other foreign currencies. In the shoe example, the cost of the shoes itself, raw materials and labor, is one component. The expense of selling the shoe, sales force labor and rent, is another.
In this example, if the local currency depreciates against the U.S. dollar, the price of the shoes, entirely made domestically, increases. This sets off inflationary pressure, which in turn causes interest rates to rise which slows economic development which decreases tax revenue. The vicious cycle never ends. Here's a suggested solution: The emerging market country in question, sells domestic currency futures against the U.S. dollar. It mandates that all rent be paid only in the local currency. It provides tax rebates to cover the cost of the purchase of these futures. This is net revenue neutral for the government and landlord so far. The price of the shoes will no longer change. Consumers will no longer need to horde dollars in the event of a currency crisis because the costs of the goods and services they consume will be priced in the local currency.
Now to offset the government's currency risk: The emerging market enters into swap facilities with countries that it conducts trade with. These countries need to be big enough so that this currency risk doesn't materially affect them. China is the main candidate here with the ECB and Russia coming in second and third. The Chinese swap Yuan for the domestic currency of the emerging market. It continues to sell goods and services to this country while taking on their currency risk. China's currency is practically pegged to the dollar and it enjoys billions of dollars in trade surpluses anyway and thus doesn't have difficulty financing dollars. The swap facility allows for the emerging market to pass on its currency risk while committing purchasing Yuan denominated goods which is great for China. Should the dollar appreciate, Chinese goods will only be cheaper for the American consumer resulting in more Chinese manufacturing and economic growth.
This appears to be a win-win-win-win model for all countries involved. Emerging market economies need to partner with export powerhouse nations for the mutual benefit of all. This simple tool may help in decreasing global income inequality as well and maybe this time next year, we will be singing the praises of 2017!