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Tuesday, January 19, 2016 3:09 PM

Mexico Central Bank Warns of "Potentially Severe Shock" Caused by Credit Crunch, Seeks Emerging Market "Buyer of Last Resort"

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Fears of Emerging Market Credit Crunch 

The growing likelihood of an emerging market crunch is on the mind of Agustín Carstens, head of Mexico's central bank.

Carstens now warns of a "Potentially Severe Shock".

Central banks in emerging markets could follow counterparts in the developed world and become “market makers of last resort”, using unconventional monetary policies to try and stimulate their flatlining economies, according to Mexico’s central bank chief.

Emerging markets need to be ready for a potentially severe shock,” Mr Carstens told the Financial Times. “The adjustment could be violent and policymakers need to be ready for it.

Policymakers and economists have warned that heavy selling of EM stocks and bonds by international investors since the middle of last year threatens to provoke a credit crunch that would make it hard for EM companies to service their debts.

Many EM companies have filled up on cheap credit over the past decade, after a commodities boom and ultra-loose monetary policies led by the US Federal Reserve resulted in very low borrowing costs. As investors pull out, those costs are set to soar.

Mr Carstens said the required policy response from EM central bankers would stop short of outright “quantitative easing” or QE — the large-scale buying of financial assets undertaken by the Fed and other developed market central banks.

But it would include exchanging high risk, long-dated assets held by investors for less risky, shorter-dated central bank and government liabilities.

Operation Twist

In essence, Carstens is discussing something like "Operation Twist" in which the Fed sold short-term Treasury notes and bought long-term Treasury bonds. Supposedly, the move pressured the long-term bond yields downward.

The Fed conducted an "Operation Twist" in the 60's and again in 2011. A recent federal reserve bank study shows the move many have lowered long-term rates by a mere fifteen basis points (0.15 percentage points).

How that would help emerging markets is a mystery. And if the assets in question are not government securities, the central banks could conceivably be left holding bags that are worthless.

Intervention Causes Problems

By attempting to smooth over every recession, every bank failure, and every market hiccup, central banks have created a global economic mess.

The global economy does not need a buyer of last resort other than the free market. If prices get cheap enough, someone will buy.

China's ill-advised stock market intervention recently blew up in China's face. Switzerland's seriously misguided peg to the Euro unleashed massive volatility wiping out every foreigner foolish enough to take out loans in Swiss Francs, expecting the peg to hold.

The Fed itself has created three bubbles of increasing amplitude: Dotcom bubble, the housing bubble, and the current equity and junk bond bubbles.

Suppression of volatility does nothing but create a series of unstable pressure cookers. The lids eventually blow off the top.

Mike "Mish" Shedlock

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