Nouriel Roubini: Iceland and USA in the same boat
Not too long ago I wrote about carry trading and how the joint rate hikes of the major central banks would potentially make it a rough unwinding especially on emerging markets such as for example Iceland (FT article walled for non-subscribers). My answer was essentially left open but luckily Nouriel Roubini from the excellent RGE team (including Brad Setser) provides with a possible answer as he investigates which other countries alongside Iceland that are likely to be affected.
"So, today it is Iceland to be in trouble. But which other economies - emerging or advanced - look in part like Iceland today? The list is clear: Turkey, Hungary, Australia, New Zealand, Spain, United States. What all these countries have had in common in recent years?"
To answer this Nouriel points us to seven points;
1. A large relative current account deficit coupled with external debt and an overvalued exchange rate.
2. A bubble in house prices.
3. A falling propensity to save coupled with increased consumption relative to GDP translating into high investment in real estate driven by the house bubble.
4. A boom in credit which is feeding the asset bubble essentially making the banking system vulnerable if the bubble bursts.
5. Cross border financing of the current account deficit through the short-term cross border flows to the banking system.
6. A low stock of liquid foreign exchange reserves compared to the cross border foreign currency liabilities of the country. (USA and other advanced economies are exceptions here).
7. Some of the countries are running high fiscal deficits.
What can we then use this fine list for? Well, in the post before this I talked about the Asia economies' addiction to exports and how they represented one end of the continuum of the global economic imbalances (as also noted by Nouriel, oil exporters should also be included here). If this is true then surely the countries sharing the characteristics above must surely, at least to some extent, represent the other end with all the pressure particularly on the exchange rate this might bring with it.
Returning to Nouriel's post he also approaches the crucial question relating to the unwinding of carry trading and global imbalances, namely the question of the dollar.
Thus, is it pure financial "panic" that explains the recent contagion from the Icelandic currency to the currency and debt markets of Turkey, Hungary, Australia, New Zealand? Suddenly, in all these countries investors are realizing that the force of gravity of a large current account deficit eventually dominates the carrry trade of interest rate differentials.
Does this mean that the eventual trigger for the adjustment of the U.S. dollar has arrived?
Well not exactly because, as Nouriel notes, the dollar is shielded by the status as reserve currency which is epitomized by Asian (especially Chinese - go see Brad Setser for more on this) and oil exporters' intervention; i.e. their propensity to finance the US current account deficit through the accumulation of reserves.
However, Nouriel is very candid about whether USA can stay out of harms way for ever ...
"(...) The developing events in Iceland and, possibly, in other emerging market economies, suggest that it was wishful thinking to believe that currency crisies, contagion, financial crises and runs were a thing of the past.
In the meanwhile U.S. policymakers - both at Treasury and even some, but not all, at the Fed - live in this LaLa Land dream that the U.S. current account deficits and fiscal deficits do not matter and that the U.S. external deficit is all caused by a global savings glut or is actually a "capital account surplus" as it allegedly represents the foreigners' desire to hold U.S. assets. They - and financial markets and investors - may soon wake up from this unreal dream and face a nightmare where the U.S. looks like Iceland more than they have ever fathomed."
A scary yet plausible thought or is Nouriel underestimating the resilience of US markets here?