We're not yet at Elisabeth Kubler-Ross's five stages of grief, but the emerging markets crisis is working on it.
I think we're in Stage 3, with Stage 4 looming on the horizon. The plunge in shares of South American airline stocks on Aug. 21 is a sample of what's to come in Stage 4.
Stage 1 came when speculation that the Federal Reserve would begin to taper off its $85 billion a month in purchases of U.S. Treasuries and mortgage-backed assets as early as September produced an increase in interest rates and a reversal of cash flows that had sent $1.2 trillion into emerging economies in 2012, according to figures from HSBC. The reversal of those cash flows sent the Brazilian real to a four-year low on Aug. 22 and the Indian rupee to a new record low.
Stage 2 saw fears that attempts to defend emerging market currencies will require central banks to raise interest rates, which would cut into economic growth rates that are already falling on a slowdown in growth in China. Many developing countries have, so far, chosen to defend their currencies by intervening in the markets to buy up their local currencies and/or sell dollars.
Stage 3 is the bounce - Aug. 22 and 23 and counting -- on belief that things aren't as bad as the plunge made them seem.
Stage 4 will come when the market begins to hear the rejoinder -- yes, they are that bad -- for specific countries and companies. At this stage, the financial markets will start to discriminate between countries like Brazil with big and, so far untouched, reserves of foreign exchange, and countries such as Indonesia and Turkey with less in reserve and, therefore, more need to raise growth-stifling interest rates faster. The markets will also start to target companies with big exposures to a rising U.S. dollar and a falling local currency.
Case in point, on Aug. 21 shares of LATAM Airlines Group (LFL), South America's biggest airline and, after its acquisition of TAM, the biggest airline in Brazil, dropped 7.2% on news that the company's operating margins were being pounded by a falling real. About 57% of the costs of running an airline in Brazil -- from jet fuel to aircraft leases -- are denominated in dollars. An airline's revenue in Brazil, on the other hand, is denominated in real. If the dollar climbs against the real, the cost of jet fuel and leases in real terms rises just as the buying power of the real falls.
Extrapolate from that to whole countries. During the Bernanke bubble, it was cheaper to borrow in dollars than in local currencies. So many companies ran up big dollar-denominated loan balances. In Turkish companies, for example, total dollar loans come to $172 billion or about 22% of GDP. All those loans get to be more expensive to carry and repay as the U.S. dollar climbs against the Turkish lira.
In Stage 4, the bounce yields to renewed downward pressure on specific countries and companies.
Stage 5? Well, the crisis can go one of two ways. A continued rally in the dollar will push us back to something like the big-worry days of Stage 2. The closer we get to a potential taper in asset purchases from the Fed on Sept. 18, the more pressure emerging markets and currencies will feel. The other possibility is worries about a shutdown of the U.S. government at the end of September or a debt crisis precipitated by a battle over raising the U.S. debt ceiling in October or November could put a halt to the dollar's climb. Of course, that could send global markets down as a whole, but it would likely alleviate the specific pressures on emerging market currencies.