Article - If the U.S. pulls the blanket over itself, will emerging markets get a cold?
Policy mistakes pave economic history. In recent times, some blame Alan Greenspan’s low interest rates policy for causing the housing bubble (and hence the subsequent financial crisis). In the last five to six years, major advanced countries’ central banks have run expansionary monetary policies, including extensive unconventional monetary policies designed to increase the liquidity in financial markets and all time low interest rates, in an attempt to deal with the aftermath of the crisis and generate a renewed growth—and may have indeed succeeded in preventing an even more serious downturn.
The question today is whether this prolonged period of low interest rates created new systemic risks, for example in the form of carry trades and new asset price bubbles. Emerging markets are particularly concerned: more than $4 trillion US$ were invested in EM bonds and equities since 2008. As US policymakers move towards the normalization of their monetary policy, concerns are being raised about potential spillovers. Will emerging markets bear the brunt of the tapering?
From the “tapering talk” to the “tapering start”
In the spring 2013, the former Chairman of the Federal Reserve Board, Ben Bernanke, announced to the U.S. Congress a tapering of the Fed’s asset purchase program before the end of the year. Though widely unexpected, this triggered a reversal of expectations and was misinterpreted as a sign for an imminent rise in the US interest rates. The distortion in the yields spreads and the change in the global risk aversion made it less beneficial to invest in these countries. As predicted by Forbes and Warnock (2012), foreign investors cautiously backtracked by repatriating large amounts of capital, causing turmoil in economies subject to “hot money” flows.
Despite a turbulent summer, the Federal Open Market Committee stuck to its guns by voting the “tapering start” during its December 18th meeting. In January 2014, weak Chinese manufacturing data were released which confirmed the worsening of emerging economies’ growth prospects. These two events – combined with the fear that emerging markets may not get out of their predicament soon enough – unleashed a second wave of foreign exchange “mini-crises.” Stock markets in emerging countries plummeted by 7% (The Wall Street Journal) in just a month.
The tapering talk and its later start resulted in sharp capital-flows reversals and currencies depreciations (cf. graph below, from the Council on Foreign Relations - to see the graph, please download the article in pdf). As investors were “less willing to tolerate the currency’s lower carry trade premium” (The Economist) their domestic asset prices dropped and risk premia on external debt securities increased.
Yet, all emerging-market countries have not been similarly affected by these two foreign exchange “mini-crisis.” Those hit the hardest by the first wave were later labelled by Morgan Stanley’s analysts the “Fragile Five” (aka Brazil, India, Indonesia, South-Africa, and Turkey). While market investors were seemingly differentiating between emerging countries with sound or weak fundamentals, the second wave of currency depreciations revealed their blindness. Further unsettling the “F-Five,” it also led to serious economic disruption in other weak countries such as Argentina, Venezuela, or even Russia.
The passive-aggressive reaction of emerging-market countries“
So far it appears that markets have been fairly indiscriminate in terms of the health of countries’ external account, fiscal positions, debt loads and economic growth” (The Economist). With broad based spillovers to EMs, good macroeconomic fundamentals and capital controls have ceased to provide much insulation. The latter one might even have done more harm than good as “financial repression is hardly painless and almost certainly reduces the allocative efficiency of credit markets, thereby impacting long-term growth” (Kenneth Rogoff). Even running down their huge amount of foreign exchange reserves no longer appears to be a viable option. Christian Lawrence shares this worry given “the ineffectiveness of intervention in Turkey, where attempts to halt the pace of lira depreciation through sales of foreign reserves proved literally to be a waste of money” (as reported in City AM).
The inefficiency of “umbrella strategies” to prevent currency depreciations led to balance-sheet mismatches and some private businesses are already facing the risk of bankruptcy. From today’s exception, the case of the bankrupt Brazilian oil company OGX Petroleo might become tomorrow’s norm, especially if foreign exchange reserves continue to dwindle away.
Many central banks are therefore forced to tighten their refinancing conditions in order to contain the effects of financial instability on their external liquidity and inflation rate. As shown by the below graph (to see the graph, please download the article in pdf), many EM central bankers raised policy interest rates, with risks to economic growth, and collateral damage to manufacturing sectors heavily dependent on borrowing (as shown by The New York Times).
A structural challenge
However, the root of the problem may lie in their high current account deficits, lack of good infrastructure, weak governance, and rising inequalities. The Fed cannot take the sole responsibility for these outcomes as “many emerging markets have been in trouble for quite a while, with output growth decelerating gradually and private investment declining” (Jomo Kwawe Sundaram).
Structural reforms in emerging markets therefore need to be wide-ranging. Coordination of policies globally would also help economic growth—quid of China letting its currency appreciate to reduce its current account surplus and strengthen its trading partners’ economic prospects?
According to the IMF, the exit from unconventional monetary policy is a powerful incentive for emerging markets to start reforms rather than a sign that “international monetary cooperation has broken down” (Raghuram Rajan). The set of recommendations is well known, including the need to develop domestic financial markets to smooth volatility in foreign capital flows (as explained in this VoxEU piece). Developing the access to financial services could also foster remittance flows whose low volatility could help emerging countries finance their external needs (as shown by the VoxEU piece).
A strong political will is required to ensure the implementation of such policies, which may be missing today. Nouriel Roubini reminds us that elections are being held throughout the year in many emerging countries, such as Hungary (April), Turkey (March and August), Indonesia (July), etc. (cf. map below - to see the map, please download the article in pdf). Political unrest could become the next main factor explaining capital outflows.
The disturbances ahead
Given those vulnerabilities, policy mistakes may turn costly. How to assess Janeth Yellen’s decision to pursue the tapering? As decided during the latest FOMC meeting, the Fed’s mortgage-backed securities and Treasury securities’ holdings will be diminished by another $10 billion in April. Perhaps of greater significance is the decision to move away from forward guidance as the above 2% inflation and below 6.5% unemployment rate thresholds appear to have become irrelevant.
The spirit of policy coordination seems behind us, if one looks at the Fed’s decision against the G20’s call for the US policy to be more “carefully calibrated and clearly communicated.” Indeed, markets are anticipating Fed fund rates to start rising again as early as the spring of 2015 (cf. graph below - to see the graph, please download the article in pdf), while the newly appointed Chairwoman only said they might wait for a “considerable time after the asset purchase program ends” to do so.
Tapering will have a real impact on emerging markets. The Institute of International Finance estimates that “if market expectations for the U.S. policy interest rate were to rise from the current 1% at end-2015 to 2%, this could result in a retrenchment of [emerging markets’] portfolio flows of around $43 billion.” Similarly, IMF economists have found that the recent “extension in portfolio duration well above the historical norm (...) significantly raises the sensitivity of portfolios to rising interest rates.” According to their estimates, a 100 basis point increase in interest rates (from current levels) could induce “higher aggregate losses on global bond portfolios.” And since the current level of liquidity worldwide is much higher than in the 1990’s, another sharp withdrawal of foreign capital could have a significant and costly impact.
Further market reaction about the future normalization of monetary policy could put both emerging-markets and advanced economies under greater strain and spark another major retrenchment in capital flows—the IMF’s “worst case scenario.” It would induce structural reductions in market liquidity and major portfolio losses that could potentially lead to forced asset sales (hedge funds managers being compelled to sell higher-yielding assets in order to cover for their losses). Besides, as mentioned by Kenneth Rogoff, “equity and bond markets in the developing world remain relatively illiquid, even after the long boom. Thus, even modest portfolio shifts can still lead to big price swings.”
Since recent events have clearly shown that advanced central banks’ actions can spur intense volatility in emerging countries, policy coordination is dearly needed. For José Antonio Ocampo, turning a deaf ear to emerging-market countries’ repetitive calls for a greater coordination is unfair considering the “considerable benefits that stable and prosperous emerging countries bring to the world economy” and have brought following the recent economic debacle. Adair Turner underlines the fact that the Fed’s tapering can only be seen as the first step taken towards a complete exit from unconventional monetary policy and that the worst might be yet to come. If emerging-market countries fail to implement ambitious structural reforms or if the Fed persists in its belief that “America’s stake in [emerging countries]’ financial stability is limited to the extent to which volatility poses a risk to the near-term US economic outlook” (Ngaire Woods and Geoffrey Gertz), then the exit from the Fed, the ECB, the Bank of England and the Bank of Japan’s unconventional monetary policies will certainly generate new waves of exchange rate crises that have the potential to morph into a full-blown economic crisis.
Another solution would be to build a new international monetary framework “à la Bretton-Woods” or at least strengthen the IMF’s responsibility for international financial stability, but the US Congress refusal to “authorize an increase in America’s quota subscription to the IMF” (Barry Eichengreen) clearly goes in the wrong direction.
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