Don't Believe The Spin: Fed Is Not To Blame For Emerging Market Turmoil

by: Austrolib

Emerging market currencies are continuing their collapse, this time with the Brazilian real on the front line.

Emerging market central banks are blaming the Federal Reserve for this for shrinking its balance sheet and causing a dollar shortage.

Pinning the blame on the Fed is scapegoating, looking for something else to blame besides their disastrously loose monetary policies.

The real blame is the extraordinary inflation of the money supply for these countries relative to the dollar supply since 2008.

Emerging market (EEM) currencies continue their race to the bottom, the prevailing theory as to why this is happening is that the Fed's shrinking of its balance sheet is creating a dollar shortage. Since emerging markets typically borrow in dollars and earn their incomes in local currency, emerging market firms are panicking because they will have to repay their debt in more valuable dollars over time. This causes a rush into the dollar and a rush out of the local currency, exacerbated by hedge funds who capitalize on these trends and short the currency to try to get the local central bank to de-peg from the dollar, and then cover.

The latter part may be true, but the initial explanation having to do with the Fed shrinking its balance sheet makes little sense when put in context. Even though the central banks of Brazil (EWZ), Argentina (ARGT), and Turkey (TUR), where the emerging market rout has deteriorated of late, are blaming the Fed for this, this looks to be simply scapegoating as a cover to hide the failures of their own monetary policies.

My thesis in this article is this: Emerging market currencies are collapsing not because of the Fed's balance sheet nor any dollar shortage, but because of reckless monetary policies from these countries, the consequences of which are now coming home to roost. Soon, these same consequences will come home to roost at the doorstep of the world's leading currencies, the dollar, yen, and euro. In a word, it's not that these collapsing emerging market currencies are failing relative to developed market currencies. It's just that they are leading the next relay round in the global race to the bottom.

The importance of understanding this is in recognizing that developed market currencies like the dollar and euro have the same problems, just to a slightly lesser degree. What's happening to emerging market currencies now is just a preview of what is going to happen to developed market currencies. This is not just a peculiarity of the Fed shrinking its balance sheet by a miniscule degree. And just as the stock markets of these countries are also declining along with their currencies and bond markets, the same will happen to the dollar and euro in due time.

The Evidence

Let's analyze the moves of the three collapsing currencies in relation to the monetary policy that has governed each of them since 2008. This is the Brazilian real, the Turkish lira and the Argentine peso in context.

Year to date, the real has fallen 11.6% relative to the dollar, the lira 18%, and the peso 36%. Why should the Brazilian real fall slightly less than the lira, which has fallen at only half the rate of the peso, so far?

Well, let's look at the M2 Brazilian real supply, lira supply, and peso supply since 2008. Brazil's money supply since October 2008, just before the Fed began QE1 and kicked off a round of record global monetary easing, stood at R$1 trillion, and is now at $2.5 trillion, for an increase of 150%. That sounds like a lot, and it is, but among the three collapsing currencies, the real is performing the relative best.

Consider the Turkish M2 lira supply since October 2008, and it is even more extreme. It has increased from₺400B to ₺1.72 trillion in 10 years, a 330% increase.

Just based on these two charts, we can begin to understand why the lira is performing worse than the real. But the Argentine peso takes the cake. Here's Argentina's money supply since October 2008.

Here we're looking at an increase from $160 billion to $1.665 trillion, a gargantuan 940% increase in less than 10 years. No wonder why Argentina's currency is getting absolutely smashed relative to the lira and real.

Now granted, money supply is not the exclusive factor that has influenced the falls of these currencies. There are certainly other reasons why a currency would fall relative to the dollar, such as sanctions, the collapse of a specific market that the currency's value is heavily reliant on, such as the case with the Russian ruble's crash in 2014 together with oil. My point is not to say this is the only reason, but that it is being completely overlooked by mainstream media who are busy hawking a tiny little blip in the Fed's balance sheet as the ultimate cause. To me, this is just loopy, and by focusing on it we are aiding and abetting these reckless central banks escape responsibility for the national stress they have helped cause.

We can put this in perspective still further, and look at Venezuela, the quintessential collapsing currency of this decade. The bolivar has been inflated into absolute oblivion, from Bs204 billion to Bs 423.77 trillion, an increase of (drum roll please) 207,630% percent.

Venezuela Money Supply Since October 2008 (I'm not even sure I got that right, but it's an astronomical amount.) Venezuela is an extreme case, but the main cause is the same. Inflation of the money supply. Inflate it irresponsibly like Argentina, and you'll cause serious national hardship. Inflate it insanely like Venezuela, and you'll cause mass starvation.

This all compares to dollar supply expansion of "only" 82% ($7.687 trillion to now $14 trillion) since October 2008. The Fed's monetary policy has been the loosest in American history, but nothing compared to the looseness of these emerging markets.

Blaming the Fed is a Weak Argument

Now let's consider the other argument, namely that the Fed is to blame for shrinking its balance sheet, as these central banks have suggested. Here's the Fed's balance sheet since that same month, October 2008.

That tiny little dip you see at the end of the chart is a decrease of 3.56%. Now, proponents of the microscopic decline in the Fed's balance sheet as the prime cause of emerging market turmoil would say that those currencies are anticipating a severe drop in the balance sheet and a prolonged dollar shortage as a result of the rate hike cycle being just at the beginning and the Fed's intention to continue shrinking its balance sheet and eventually normalize it. This would be a huge move and the lira, peso, and real are pricing this possibility in, or at least some of it, in advance.

I have two responses to this argument. First, much of the miniscule decline in the Fed's balance sheet that has taken place so far, has vacuumed dollars out of excess reserves rather than required reserves according to the Fed's own data. The Fed's balance sheet peaked in February 2015 at $4.47 trillion. That month, required reserves in the banking system were $161.2 billion. Total reserves were $2.74 trillion according to the H.3 release on aggregate reserves. This puts excess reserves at $2.58 trillion in February 2015. Now, the balance sheet is $4.31 trillion, required reserves at $192 billion, total at $2.09 trillion, meaning excess is now $1.896 trillion. So required reserves, the dollars actually in the banking system influencing the global economy, have expanded, while excess reserves have fallen 27%. So far, the balance sheet reduction hasn't made the slightest dent in the relevant money supply in the banking system.

As for the continuation of this argument, that the Fed will liquidate its balance sheet and this will cause the dollar shortage and it is this that emerging market currencies are pricing in, this is impossible. There is no way the Fed can continue to tighten monetary policy to that extent without causing a crash of epic proportions that would force them to quickly reverse course before they ever get close to achieving it. The reversal would smash the dollar and put wind back at the sails of these now suffering currencies.


These currencies currently suffering, minus the bolivar which is in its own cocoon of insanity, will recover, and then it will be on to the euro or dollar for the next decline, largely depending on how much longer the eurozone can keep itself together with spit.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.