The Future of the Global Dollar System (w/ Rashique Rahman & Ed Harrison)
ED HARRISON: We were talking about this before the broadcasting, I was telling you that I had seen a podcast, I've listened to a podcast where Perry Marilyn was talking about the money view about settlement risk being the biggest risk in liquidity crises. He thinks repo, in particular, is a nexus of a liquidity crisis, because the Federal Reserve and other regulators have pushed people into secured credit as the place in order to get in liquidity in repo in particular. As a result, a lot of this Eurodollar offshore funding is happening there. To the degree that you have a risk to these corporates, it's going to show up in terms of their liquidity provisions in markets like the repo market. RASHIQUE RAHMAN: Absolutely. The way I like to think about it, there's three legs to the stool in a sense. There's the stock of debt. I don't think that's a major issue, it varies by jurisdiction. Some countries have enough dollars to pay down the debt, some have last, those things. That's one leg of the stool. You do have a high redemption level this year, something like 6 trillion of that dollar debt is due this year. It's a high rollover risk this year. That gets to the second point, which is liquidity provision. It's not just the cost of the dollars which is relatively low now and that's why you're seeing this amount of issuance in the dollar market for EMs over the last couple of years, and this year is no exception so far. The cost is always one thing, but the access to the dollars is another one which you rightly point to. There are some offsets to that, which is that central banks have dollar FX reserves that they can use, they can provide swap lines and those things which many countries have done of late to provide some needed liquidity to say corporates or their entities, domestic entities that need the dollars. They can't do that well at limit, but it does provide an out for times of dollar stress, when dollars are less available. A good way to look at this is to look at the cross-currency basis. If you see a tightening in cross currency basis in dollars, that tends to be a sign of scarcity of dollars. We're not really seeing that right now. We haven't seen it for many, many years since 2011-2012. It seems to be okay on that side, but that's something to monitor for sure. I think that that's likely to be a source of significant strain for not just the EMs, but global markets when the plumbing really starts going haywire. I want to talk about the third leg and that's also one that's very much misunderstood and that's just that dynamics in the dollar. We keep talking about dollars as relates to EMs, but it's so important. EM fortunes are largely tied to the dollar, believe it or not. That's not just in terms of the stock of debt or the availability of dollars, but the direction of the dollar. The dollar strengthens or weakens, that has a pervasive impact on EM growth conditions, let's say. The reason why is because the dollar will tend to tighten or loosen domestic financial conditions for EM, and that's the exchange rate. The exchange rate for EMs is an important nominal anchor. Why? Because institutions are relatively weak, even central banks don't have the level of confidence that you have in developed markets. The currency is an important nominal anchor for EMs, and it affects balance sheets as well, the exchange rate. If you have a period of dollar strength, you'll tend to get a weakening in domestic balance sheet, so you'll tend to have erosion confidence because the domestic currency is weaker. You'll have a tightening in domestic financial conditions, credit conditions tighten. ED HARRISON: That's not what you'd see in developed markets. RASHIQUE RAHMAN: Correct. It's the opposite what you see in developed markets. Typically, when the domestic currency weakens, say versus the dollar, that's a loosening in financial conditions. That's a good thing. It's the opposite for EMs. When the dollar strengthens, the domestic currency weakens, you have a tightening in domestic financial conditions. The fact that the dollar, the real effect of dollars strengthened by something like 20% in the last five plus years has led to a tightening in domestic financial conditions for EM, and that's a big part of why EM has slowed, why growth has been so anemic, is because of the tightening in domestic financial conditions as a result of the strengthening dollar. The dollar is very prominent. It's a very important aspect of how you think about EMs in general. If you're of the view the dollar is going to remain steady to stronger, you can't be optimistic on EM growth conditions. Then as we talked about before, the fact is that social strains are increasing, that's going to lead to potential political disruption as well, so you have to bear those aspects in mind. It's not just that dollar funding rates are low there, there's a bigger part of the story to it. ED HARRISON: Were you on that score in terms of where the dollar is headed, or where it's going to remain relative to other currencies? Why? RASHIQUE RAHMAN: It's a great question. My own personal view is the dollar's likely broadly fairly value in a sense. To me, the real exchange rate is an indicator of relative competitiveness. It's a measure of relative price, not necessarily a measure of valuation per se, because that you have to bring in flows, dynamics in terms of flows, and you have to think about the equilibrium of current account and these things. In that sense, the dollar is more fairly valued than overvalued. I know there are people that disagree with that notion, but I think the dollar is broadly fairly valued. Think of this, too. It's a crazy thing but the fact is that there's a lot of demand for dollars. That's partly why it's been strong. This issuance in dollars leads to demand for dollars for repayment so it keeps the dollar relatively strong. I think that's likely to be the case going forward. Let's remember the dollar remains the safe haven, even in spite of twin deficits and those things. I think the dollar is going to remain relatively robust over the coming months and years, actually. ED HARRISON: Broadly speaking, that is slightly negative then for emerging markets. RASHIQUE RAHMAN: Absolutely, it is. That's why I like to think again, EM is a relative value opportunity, rather than a directional opportunity and that's going to be my focus, is looking at EM from a relative valuation standpoint as opposed to directional. Yeah, you'll get periods of risk on, risk off as you have in broader markets and the beta of EM is higher, so you'll tend to get better performance in risk on and worse performance in risk off. That dynamic's going to remain unchanged. I think we're in an environment where investing in EM is really going to be about picking your spots, the winners and the losers rather than taking more of a directional bet on the asset class per se. ED HARRISON: Let me ask you in terms of the dollar about this whole concept of the dollar smile, that is that when the US on a relative basis is doing well economically, the dollar is strong, because obviously, the financial conditions are going to be tighter, but then the dollar is weak when, on a relative basis, the dollar like US conditions are the same or slightly worse than everyone else, but then suddenly when there's a crisis situation, everyone wants US dollars. Is that an interesting framework, and to the degree that it is, where are we within that curve? RASHIQUE RAHMAN: I'm a proponent of that view generally. I think the dynamics have changed a bit though, where the strength of the dollar in prior cycles was the strong CapEx and the growth momentum that was generated as a result of that. We haven't seen that of late. The investment has been relatively low, and there's hope that we can see a massive pickup in the CapEx cycle. If that's true, then certainly we'll see that side of the dollar being quite prominent, inflows to the US, strengthening the dollar. The dynamics are different though now, because it's all about dollar funding. To me, it's just changed. The demand for dollars isn't so much about growth prospects for the US. There's some of that because the relative yield advantage of dollars depending on currency swap rates and things like that, there's some aspect of that. To me, it's more about the demand for dollars that we've seen as a result of the tremendous issuance of dollar denominated debt out there. That's that part of the equation. I think that's going to become and remain relatively prominent. I agree with that. The dynamics have changed. JUSTINE: If you're ready to go beyond the interview make sure you visit realvision.com where you can try real vision plus for 30 day for just $1. WE'll see you next time right here on real vision.