Since mid-2014, the trade-weighted dollar index has surged 21%. If this is indeed a new bull market in the US dollar, it is not yet fully fledged. The previous two major US dollar bull markets during the open currency era traced rises of 88% and 47% between 1980-1985 and 1995-2002, respectively.
Divergent monetary policies remain the key driver, predicated on the assumption that the Fed tightens first, whilst other major blocs retain looser monetary policy, increasing interest rate differentials. Speculative long dollar bets reached a record high earlier this year with the most extended positions against the Euro and the Yen. However, since March, with the renewal of the Greek Crisis and Chinese equity volatility grabbing headlines, the dollar has traded sideways and given up some of its earlier gains.
A stronger dollar also exerts pressure on emerging market economies, who traditionally suffer under this scenario. History suggests that disruptions occur when the Fed tightens and the dollar rises in tandem. The previous two dollar bull markets proved traumatic for, respectively, the Latin American and Asian economies in the early 1980s and late 1990s, as the burden of repaying dollar-denominated debts became intolerably expensive.
This time may also be painful for countries that have borrowed extensively in US dollars during the QE phase post the Global Financial Crisis, especially those with large currency mismatches (aka. where foreign currency borrowings is not matched by foreign currency earnings). Until 2008, developed nations have led the global debt accumulation, but since then, the emerging markets have taken over the driver’s seat as capital flowed in from investors chasing after yields overseas. Data from the Bank of International Settlements (BIS) estimates that offshore US dollar lending has grown to US$9 trillion from US$6 trillion pre-2008. Emerging markets are, once again, on the receiving end of a large proportion of this credit, as seen below.
Exhibit: US dollar credit to non-banks outside the United States (in USD Trillions)
Whilst Southeast Asia learned hard lessons from 1998, China, which escaped the Asian Financial Crisis, appears to have not. It has become a fervent borrower: out of the estimated US$4 trillion that flowed into the emerging markets, it alone accounted for over US$1.1 trillion, with the majority of the credit disbursed in the form of loans. In the below chart, the other two BRIC nations, Brazil and India, pale by comparison.
Exhibit: US dollar credit to Brazil, China and India (in USD Billions)
China’s corporate debt sector currently stands at close to 200% of GDP (including financials), having doubled from 2007 levels. Its issuance of US dollar bonds is also 11 times larger than it was in January 2007, as illustrated by the chart below.
Exhibit: China foreign currency bonds outstanding by issuer (in USD Billions)
Source: Asian Bonds Online
Almost 25% of aggregate Chinese corporate debt is dollar-denominated, but only 9% of Chinese corporate earnings are. The difference between these two figures defines the mismatch. The Chinese real estate sector is the worst offender, where approximately 50% of the debt is concentrated. The second biggest borrower is the utilities sector. These sectors also have the greatest currency mismatch as the majority of the revenues will be in local currency, with exposures generally unhedged.
Exhibit: China currency mismatch by debt and EBITDA
Source: Morgan Stanley
However, whilst China’s aggregate debt level appears high in absolute terms, it must be noted that a large proportion of this is domestically held. The triggering factor for most major defaults is often a consequence of large external borrowings, an area where China remains relatively robust. Its overall gross external indebtedness is low at 9% of GDP as at end-2014, not a level that raises immediate concern (conventionally alarm bells ring when level reaches 35% of GDP). China has ample foreign reserves for coverage (US$3.6 trillion or 4x covered) in the event of distress. On the other hand, many other emerging nations appear vulnerable on this measure, including much of EEMEA. In emerging Asia, the weak link is Malaysia and in Latam, Chile.
Exhibit: Gross external debt as a % of GDP, Q4 2014 (in USD Billions)
Source: World Bank
Outside China, the picture in emerging Asia seems more reassuring in general: on average 22% of their overall debt is dollar-denominated, balanced in large by their 21% dollar earnings. With flexible currencies, adequate FX reserves and a larger proportion of local currency denominated bonds, the Asian economies should be more resilient than during previous periods of dollar strength.
Nevertheless, pockets of vulnerabilities do exist and contagion risk is not improbable. Growth has slowed in many countries, markedly in China, but also in major borrowers including Brazil, Turkey, Russia and South Africa. These latter countries must service dollar debt using energy sector revenues, which have been exposed to recent falls in oil prices that may persist for longer with Iranian supplies back on the map. In other cases, current account deficits are funded by short-term capital inflows. Turkey, Argentina, Malaysia and Mexico all have short-term borrowings of over 50% of reserves.
Exhibit: EM external liabilities by currency composition
Source: UBS, Haver
As a large proportion of emerging market debt is held by foreign investors, many will be quick to retract their capital should sentiment deteriorate materially over any signs of distress. Once the cycle begins, EM companies will find it incrementally more difficult to roll-over dollar denominated loans, which form a large percentage of their external liabilities as exhibited above. This will, in turn, drive a demand for the US dollar, causing it to appreciate in value, push up the local currency value of the debt, thus making it more burdensome to service, generating a self-reinforcing downward spiral. Foreign holders of local currency denominated debt may also want to exchange it for US dollars, further driving demand.
Capital outflows in emerging markets have begun to build since the ‘taper tantrum’ in May 2013, as illustrated by the EM debt fund flows chart below. Capital flows in China have also turned negative for four consecutive quarters, recording a capital and financial account deficit of US$78bn in the first quarter of 2015, the largest since 1998, despite the small absolute value. This is partially due to a slowing Chinese economy and the result of a rising US dollar coinciding with declining Chinese interest rates. With the Fed holding on to their expectation of a 0.5% interest rate rise this year, the tendency is for these trends to accelerate.
Exhibit: EM debt fund flows (in USD Billions)
Exhibit: China Capital Flows (in USD Hundred Millions)
Source: Trading Economics
The argument for a stronger dollar rests on the relative strength in the US economy versus other major economies, met by interest rate rises against a background of some vulnerability in emerging markets. Now that the uncertainties brought by Greece and Chinese equities have somewhat abated, for the time being, the dollar has resumed its upward trend as focus is reverted back to the Fed’s interest rate policies.
Exhibit: Trade-weighted US dollar index (DXY) since 1970
A strong dollar creates countervailing pressures, particularly through the import of deflation and a depressant effect on US corporate earnings. Standard & Poors estimates that approximately 46% of sales of S&P 500 companies are derived internationally, thus, a strengthening dollar will directly affect US multinationals’ corporate earnings. Further, US inflation was more shielded to exchange rate fluctuations during the 1990s, and US import prices were much less volatile, as Barclays Research suggests.
Exhibit: US dollar on PPP (top) and REER (bottom) measures against a basket of DM currencies
Source: ValuTrac, Bloomberg
On valuation grounds, the US dollar is not overly expensive relative to its previous peaks on REER and PPP basis, against a basket of DM currencies, as exhibited above. Although worryingly, investor positioning remains at somewhat elevated levels: two standard deviations above the long-term average despite some moderation since the trade-weighted dollar index backtracked from its recent high in March.
Exhibit: Net speculative positions on the US dollar
Source: Morgan Stanley
We tend to think that there is less potential for steep dollar appreciation this time round due to better EM fundamentals than during the previous dollar bull markets, in particular emerging Asia, and also due to the possible negative implications of a strong dollar for the US economy. We, therefore, expect the dollar to resume a milder climb onward, with more volatility in tow.