EM “Hot Money” Doesn’t Come Home; It Just Dies In The Global Dollar Short

Terminology and semantics have an important place in communication because we want to convey concise and accurate meaning as efficiently as possible. That is why I disdain the term “petrodollar” when speaking or writing about the global exchange standard that replaced gold in the Bretton Woods sense. The idea of a “petrodollar” conveys some of the “right” characteristics but leaves out so many other vital pieces as to be leaning more toward misleading (especially history, since the eurodollar and swap pieces long predated the oil finance arrangements of the 1970’s).

The same, for me, can be said of the term “hot money.” When referring to global financial flows, there is some truth to the idea just as there is with “petrodollar.” And, in the same sense, “hot money” misses out on very important ideas that are crucial to understanding.

When using the words “hot money” the conventional idea is one of “flow”, as in a flow of hot money into usually an emerging market that props up various asset prices and causes all sorts of indiscretions and re-arrangements. The reverse condition as it relates to “hot money” conjures an idea of “capital” somehow returning back to its origin. Thus, an “outflow” of “hot money” tends to spark expectations of rising participation in domestic dollar “markets.”

It is that last part that misses the vital distinction in the eurodollar standard – there is no repatriation of “capital.” If “hot money” is receding in participation in foreign shores it is not going or seeking “elsewhere” but rather relates to the always changing global dollar short. Like a balloon, the dollar short growing ever shorter (more “dollars” on offer at cheaper rates) is the global finance system filling up and acting like a “hot money” inflow. We have been told that “money” can never be destroyed except by a central bank, but that is plainly false in the modern monetary sense where bank balance sheet capacity is every bit a form of currency creation and “money supply”; I would argue forcefully that bank balance sheet capacity is, in fact, more modern “money” than anything offered by a central bank.

That reverse situation is the dollar short growing more problematic, as in 2013, 2011 or 2008, thus the balloon shrinking. What is certainly appearing as an “outflow” to the emerging market filled by the dollar movements in expansion is not an inflow to domestic markets or anywhere else, but rather a simple shrinkage in total “dollar” participation broadly. It is the essence of cumulative balance sheet “flexing” in and out.

We can observe this very clearly in the context of what has transpired recently, and going back to encompass the whole of the “taper” concept.

ABOOK Oct 2014 Dollar Short Real Bovespa

Using yesterday’s proxy, the Brazilian real, there is a very clear relationship and close correlation between the US$ availability (shown by the currency exchange value) and the Brazilian stock market. When dollars are relatively plentiful, so is the asset inflation of “hot money.” When dollars are tight, the real devaluing sharply, stocks and commentary about stocks speaks of “hot money” reversing.

If there was a sort of zero sum game to all this “hot money” there would be at least a minor imprint on the US markets. There is none, not even the slightest correlation with the “dollar”, the global dollar short or any inflections in EM.

ABOOK Oct 2014 Dollar Short Real Bovespa SP500

This analysis is not limited to Brazil, as it is just as clear across the majority of emerging markets, their currencies and “hot money.”

ABOOK Oct 2014 Dollar Short Real EEM2

That raises the question as to why eurodollar availability so dramatically effects “hot money” but not domestic markets. And the answer is simply why the term “hot money” is alluring to begin with – domestic market liquidity is not dependent on eurodollar creation, where instead global financial flows most decidedly are and with greater marginal effect. That doesn’t mean that domestic dollar markets are totally immune; on the contrary, they are very susceptible to disruption (growing more so, though nobody seems to want to notice) but at a much higher tolerance. That was the essence of the 2007-08 reversal which was severe enough to be global in its reach, including the domestic dollar market.

That realization seems to cleave the “dollar” somewhat into what may appear to be two different systems or “markets”, but they are indeed linked and form a whole that circumvents geography as well as other relevant factors like accounting and banking.

With the dollar now being given primary attention, even suddenly at the FOMC which was so hoping for clear sailing into QE goodnight, so too must “hot money” and its third reversal in less than eighteen months. As the charts above show, emerging markets and even Brazilian stocks may have gotten a little too comfortable with what appeared to be benign dollar conditions this year. With central banks having undertaken in many cases severe countermeasures (like India) there may have been a tendency to be far too optimistic about the efficacy of them in isolation and cumulatively.

However, it was only a year ago that the World Bank essentially warned of rough days ahead given dollar constraints surrounding taper (contrary to orthodox blather, I think it well established by now that taper does equal tightening, even if only in the farther reaches of the eurodollar standard and hot money to this point).

We think that now emerging market economies have maybe a two- or three-month window and the message we want to send to everybody is now is the time to make the reforms that you need to make.

Instead, the various central banks acted as various central banks are want to do and simply tried (and succeeded) to extend that window (or kick the can) as far into the future as possible. Given what is setting up now, assuming that it continues in dollar tightening, the “window” stretched for nearly a year, though most importantly with none of the actual “reforms” or “global growth” anticipated. Recession is once again a global concern, in sharp contrast to what everyone asserted just as tapering in QE began.

Some may take comfort in that all those “dollars” must be coming “home” to shelter, but that is as false as the idea of central banks offering durable solutions. A financing problem of the global dollar short is a global financing problem.