by Ari Pine
Michael Pettis wrote The Volatility Machine 20 years ago as I write this in 2022.Many finance books are focused on a narrow subject that may be applicable for a certain time, regime, or market.Pettis analyzed and wrote a long term historical perspective to apply an overall framework for thinking about crises in Emerging Market economies.He accomplished what he set out to do.He built his framework from a combination of first principles and empirical data.
Therefore, we can take from his writing a more general set of principles applicable across markets and time.
Pettis starts with a few big, fundamental ideas that individually and together do an excellent job explaining emerging market economic dynamics — swinging between expansion and crisis.In addition, they transfer well to other markets.An additional aspect is that these ideas can by used as criteria to suggest that certain markets are emerging markets (or emerging market style) even though they are not necessarily widely considered as such.
Pettis’s big, fundamental ideas:
Price and volatility dynamics of crises are not determined by traders making rational decisions about value.
Instead, they are pre-determined by legal-contractual obligations put into place long before any crisis occurs.Those obligations dictate the actions of key market participants by forcing liquidations.Expansion of emerging market economies is determined primarily by liquidity flows emanating from the major global capital centers.Likewise, contraction and crisis occur when liquidity contracts and withdraws back to those capital centers.Funding via both equity and debt includes embedded optionality.The nature of the funding, the pricing of the securities, and the market conditions domestically and abroad, dictate whether long or short convexity dominates for investors.
Risk management is not about a failure to predict an outcome.It is about having a neutral outlook and, for corporate and sovereign issuers, creating a capital market structure design so that one is not subject to catastrophe.
Emerging markets are not crippled by crisis, Instead, they are crippled from a sustained drought of incoming capital investment that occurs when the crisis is not handled properly.Catastrophe occurs when the combination of money outflow causes asset price decline, leading to currency decline, leading to forced selling on the part of investors, and the corporate sector.These key observations / hypotheses lead to important implications:
Good policy is not the cause of expansion; crisis is not caused by bad policy.Sovereign policy makers should focus on the fact that their economy is being impacted by forces outside their control.
Therefore, they should realize that their policy is not at fault, and that they should plan for a neutral outcome.Debt issuance should focus on laddered maturities and extending duration of bond issuance.Debt issuance should be in local currency as it is correlated with the economic fortunes of the nation.Another way of putting this is “outlook neutral”.
It aligns the fortunes of the investor/creditor with that of the nation and functions a bit like equity where both investor and issuer outcomes are tied together.Although it costs more initially to issue, Pettis shows that the real cost shows up during crisis when non-local debt causes a vicious downward spiral.And over time, eliminating that tail event reduces the overall cost of debt.Planning should accommodate boom-bust cycles and crises so that foreign investment returns as soon as possible.The ultimate point for sovereign issuers is:
Avoid being put into a position to get forced into selling local currency to raise foreign reserves at inopportune times.There are not good bankruptcy/default procedures for sovereigns, and this delays capital from flowing back into the country — which is the key to moving beyond the crisis.
Avoiding having “too much” debt coming due at the same time and creating a liquidity crisis for the sovereign.Pettis took the time to turn observations into a framework.
He made this explicit by referring to the “capital structure” and in its role to create or dissipate crises or volatility.From that comes the title “The Volatility Machine”.The important part about building a framework is utilize the lessons from the narrow specific instance to a more broadly applicable analysis.
A framework is leverageable, for example in cryptocurrency markets.
What lessons are there for crypto? My observations of cryptocurrency markets strike me as similar to emerging markets as defined by the above criteria.Digital assets are driven by capital flows from major capital centers.Of course, this is not divided by geography but rather by connections and dis-connections from the banking system — be it USD or EUR or RMB.These flows are outside the control of those running digital asset projects.Like emerging markets, all of these projects — like nations — believe that the quality of their project (or the quality of their reform) is what is driving the inflows.
And it is not that there are not quality projects just as the economic reforms can be good and successful.It is just that, at least by tracking flows and performance, it is the flows that drive the reform and not the other way around.To be clear, there is demonstrable and sufficient data to show this for emerging market economies.Realistically, the digital asset market is still too new for this to be more than a reasonable hypothesis because the history thus far only includes a single secular monetary expansion that, essentially, birthed it.
Investors don’t typically buy currencies for their own sake but rather for the investment opportunity set to earn returns denominated in that currency.
This is the future for digital assets.Pettis suggests how to do this prudently.
How can cryptocurrency projects take advantage of this? By following the risk management maxim to have a neutral outlook: flows will come and go; corporate finance ensures the continuity of the business.It is the responsibility of the prudent manager to secure long term funding when it is cheap, manage liquidity terms, and any debt issued ought to be in “local” currency to ensure the capability of repayment.It is no coincidence that Pettis notes that the two emerging markets — the US and Japan — always had USD and Yen denominated debt exclusively.
Right now, much of the digital asset financing markets are focused on raising USD or other fiat backed by crypto assets.
This is the equivalent of emerging market sovereigns borrowing in USD.This is a dangerous path and exacerbates the volatility of crypto currencies.With institutional investors entering the market there will soon become a vibrant debt market.After all, investors don’t typically buy currencies for their own sake but rather for the investment opportunity set to earn returns denominated in that currency.This is both the future for digital assets and the way that “local” companies and the overall space become more robust to currency swings (and ironically how those swings become smaller)..
