Nouriel Roubini | Mar 28, 2006
The recent speculative attack against the Icelandic currency and the incipient run on its banks is no news (actually a deja-vu as my co-author Brad Setser says) to students of financial crises in emerging market economies; Brad and I wrote an entire book about it. A combination of a large and growing current account deficit, driven in part by a credit boom and an asset bubble (with housing bubbles leading to an excessive growth in real estate investment and an excessive increase in private consumption and fall in private savings) can be deadly if it goes bust and it triggers a domestic and/or international run on a banking system with large foreign currency liabilities and little liquid reserves. The combination of weakening fundamentals and illiquid banks can lead to a panicky currency and liquidity run: we saw it in Mexico in 1994, in East Asia in 1997-98, in Brazil in 1999 and in 2001-2002, in Turkey in 2001. Add to these problems, a fiscal imbalance and high public debt and you may even get a sovereign debt crisis, as in Ecuador, Russia, Argentina, Uruguay.
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?
First, a large (relative to GDP) current account deficit, a large (relative to exports) external debt and a significantly overvalued exchange rate.
Second, an asset bubble in the housing sector.
Third, a fall in the private savings rate and an increase in the consumption to GDP rate, as well as a boom in real estate investment that are all driven by the housing bubble; these, in turn, lead to a worsening of the current account.
Fourth, a credit boom that has fed this asset bubble and that can make their banking system vulnerable to a housing bust.
Fifth, a partial cross border financing of the current account deficit via the short-term cross border flows to the banking system that currently is mostly in domestic currency (but that in some cases used to be in foreign currency).
Sixth, a relatively low stock of liquid foreign exchange reserves relative to the cross border foreign currency liabilities of the country (the U.S. and advanced economies being an exception as they have little forex reserves but also little foreign currency debt).
On top of all these vulnerabilities, some but not all of these countries - the U.S. in particular - have also a large fiscal deficit.
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. It is true that the large current account deficits of these countries and their housing bubbles have been known for a while. But markets and investors have a strange way of sometimes waking up - as they did in Thailand in 1997 - and realize that the problems in one country - Iceland today (Thailand in 1997) - are very similar to those in other countries (East Asia in 1997 and the "usual suspects" above today).
Does this mean that the eventual trigger for the adjustment of the U.S. dollar has arrived? Not yet for the U.S. dollar; but certaintly you see now the beginning of the stress on the currencies of Hungary, Turkey, Australia, New Zealand. The U.S. is only partiallly different: still the dominant reserve currency; still being supported by massive intervention by China, other Asian countries, oil exporters and other emerging economies with current account surpluses; still with limited reserves but also with limited foreign currency debt.
But you can play your luck only for so long, especially when - unlike all these other economies - you also have a large and growing fiscal deficit and you are increasingly financing it with new short term debt that is 100% purchased - on net - by non-residents that are now subject to a serious currency risk. It used to be argued that short term foreign currency debt is dangerous when you have little foreign currency reserves as liquidity runs can occur; while domestic currency debt is less risky as you do not have the same rollover/liqudity risk; it was also argued that, as the currency risk is held by the non-residents holding your local currency debt, no nasty balance sheet effects of a devaluation can occur.
But these argument are probably flawed: if most of your domestic debt is in local currency and is held by non-residents, these investors face a large currency risk. Thus, once they start to expect a large depreciation of your currency, their incentive to hedge their currency risk and dump your assets and your currency becomes very large. Then, both a currency crisis and a run on your assets - be it liquid bank deposits or short term government debt -may occur - with nasty effects on your financial system and the ability of your government to finance itself. So, the fact that U.S., Spain, Australia, New Zealand and now even emerging markets such as Turkey and Hungary are financing themselves in local currency may be of little comfort. Runs on currency and liquid local assets may still occur with severe and disruptive effects on currency values, bond markets, equity markets and the housing market.
I have been warning for a while - as Morris Goldstein did - that the new crises in emerging market economies may take a different form from the traditional ones where large stocks of short-term foreign currency debt and low levels of forex reserves could cause a run and an external debt crisis. Instead, runs on the short-term domestic local currency debts of governments and banks could still occur - even in the absence of those traditional external vulnerabilities - and lead to a new type of financial crises. 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.
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