When the Fed sneezes, emerging countries catch a cold!

Summary:

– Ben Bernanke’s speech on May 22, 2013 caused turmoil on financial markets around the world. The Federal Reserve (Fed) will soon begin to reduce the amount of assets it purchases under its QE3 program: « Fed tapering. »

– This was followed by a sell-off [1] of emerging market assets: major emerging financial markets with large current account deficits (Brazil, Indonesia, India, Turkey, South Africa, etc.) experienced massive capital outflows, which led in particular to a decline in their currencies against the dollar.

– The conventional monetary policy tools used by emerging market central banks (key interest rates, foreign exchange reserves, etc.) appear to have had a limited effect in supporting heavily battered local currencies.

– The response to the Fed’s gradual phasing out of its ultra-unconventional policy seems to be for emerging market central banks to adopt unconventional policies, as Brazil did very recently.

Portfolio investment capital flows to emerging countries are inherently volatile. This volatility can lead to massive capital withdrawals without discernment or selectivity (i.e., sudden stops). As a result, economic and financial imbalances can threaten emerging countries. Despite their stated growth and inflation targets, emerging economies are struggling to convince market players of their economic and financial health and therefore their attractiveness (i.e., pull factors). And for good reason: the ultra-unconventional monetary policies adopted by developed economies in recent years have considerably weakened the credibility of central banks in emerging countries.

Towards a likely end to the Federal Reserve’s QE3…

In recent years, the excess liquidity resulting from the Fed’s ultra-unconventional monetary policy has contributed to market turmoil. It is primarily the equity markets and the rebound in the US real estate market that have triggered a wealth effect, even as employment and wages are showing the first signs of recovery. To prevent the upturn from turning into a boom, the Federal Reserve (Fed) has decided to take action.

The speech given by Ben Bernanke, the current Fed chairman, on May 22, 2013, caused turmoil on financial markets around the world. Since this intervention, the anticipated end of the Fed’s third wave of quantitative easing (QE3) has been given a name:  » Fed tapering  » (i.e., a gradual reduction in the pace of asset purchases). According to the current consensus among many economists around the world, it appears that the Fed is seriously considering adjusting its QE3 program before the end of 2013. However, this is by no means a monetary tightening, but rather the first step toward a less accommodative monetary policy. It is important to distinguish between monetary easing (QE) policy, which relates to liquidity, and the policy of very low key interest rates, which is more focused on the economic cycle [2]; the former will end before the latter.

Initially, asset purchases under QE3 began in September 2012 with $40 billion per month of mortgage-backed securities (MBS) purchases. In December, the Fed decided to supplement these operations by adding $45 billion in purchases of US Treasury bonds. With $85 billion in asset purchases per month, the Fed’s balance sheet has thus increased by nearly 25% since the start of QE3 and by more than 50% since the start of the first QE in November 2010. Furthermore, unlike the first two episodes, QE3 is unique in that it is not time-bound, hence its initial name of « infinite QE. »

Following this announcement, dissension began to emerge within the Fed, with several voting members becoming less and less dovish. At present, the only certainty is that QE3 will be adjusted until it is phased out, but neither the amounts involved nor the exact timing are known to market participants. On the other hand, Fed tapering is conditional on the improvement and sustained performance of key macroeconomic data such as the unemployment rate and inflation. Following Ben Bernanke’s comments to the Federal Open Market Committee ( FOMC), the House of Representatives, and then the Senate, the 10-year U.S. Treasury bond yield jumped by more than 80 basis points, reflecting the change in market participants’ long-term rate expectations. This rise in US rates automatically affected emerging market sovereign bond yields denominated in dollars initially, and then those denominated in local currencies.

The excess liquidity created by ultra-accommodative unconventional monetary policies triggered a search for yield that was, in retrospect, beneficial for emerging markets in a fairly favorable economic environment (e.g., strong real growth, low inflation, accumulation of foreign exchange reserves, stable or even appreciating exchange rates, etc.). Since expectations of a slowdown and then the end of QE3 have become more pronounced, liquidity needs (mainly in dollars) have become increasingly strong. As a result, emerging countries are experiencing a sharp withdrawal of foreign capital, which has led to a sharp depreciation of emerging market currencies and corrections in these countries’ main equity and bond markets. This raises the question of how much room for maneuver emerging market central banks have left to curb sometimes rampant inflation and maintain control over their currencies.

The « fear of floating » gives rise to a conflict of objectives!

Emerging countries are commonly victims of « original sin, » as Eichengreen and Hausmann (1999) point out. This expression characterizes the fact that emerging countries find it difficult to issue bonds in local currencies, resulting in a preponderance of borrowing in hard currencies, mainly dollars. This excessive dollarization of emerging countries’ external debt automatically creates a foreign exchange risk for these countries and can sometimes lead to the phenomenon of « floating fear » highlighted by Calvo and Reinhart (2002). This fear is defined as the reluctance of emerging economies to allow their currencies to float freely, particularly for fear that the exchange rate will depreciate sharply and severely undermine the stability of their banking and financial systems. However, when a central bank adopts an inflation targeting policy, its exchange rate becomes de facto flexible (Lucotte, 2012) and it is therefore legitimate for the central bank to set a target for its currency. Furthermore, according to Mundell’s (1960) incompatibility triangle, it is theoretically impossible for a country to reconcile free movement of capital, monetary policy autonomy, and exchange rate pegging.

As a result, central banks in emerging countries that target inflation have pursued managed floating exchange rate policies, notably through the accumulation of large foreign exchange reserves (mainly in dollars). These monetary policy tools worked well while market players had access to « cheap » liquidity from the Fed, the Bank of England (BoE), and the Bank of Japan (BoJ), and investors were seeking returns. But this situation was reversed following the speech on May 22, 2013: investors repatriated their capital from emerging economies, in which confidence had eroded, to developed economies, which offer slightly more attractive returns for a risk that is in principle controlled and normally better understood. What can we conclude from this? The conventional monetary policy tools used by emerging countries no longer seem to correspond to their initial objectives: managing inflation and currency fluctuations. The tightening of monetary policy by emerging market central banks (i.e., mainly through interest rate hikes) is aimed at bringing inflation back to acceptable levels and attracting investors seeking returns (particularly through carry trades [5]). However, these conventional tools have had limited power since the emergence of unconventional monetary policies pursued by central banks in developed countries.

As mentioned earlier, significant withdrawals of foreign capital have destabilized the economic and financial balances of emerging markets, which are also experiencing inflation levels (largely imported by the excess liquidity induced by the ultra-accommodative monetary policies of developed economies) that are sometimes well above the rates targeted by the central banks of these countries [6]: +10.8% in India, +8.9% in Turkey, +8.6% in Indonesia, +6.3% in Brazil and South Africa. And what about the markets in all this?

Since Ben Bernanke’s speech on May 22, 2013

In the foreign exchange, sovereign bond and equity markets, we can make the following observations [7]:

These markets have experienced very high volatility, with, for example, the VXY-EM index (developed by JP Morgan, which tracks the implied 3-month volatility of emerging market currencies) returning to its long-term average of around 12, after being abnormally low until then. This is therefore more a normalization than a real increase in volatility on emerging market currencies.

– Emerging market currencies have depreciated sharply against the dollar: -16.6% for the Indian rupee, -14.2% for the Brazilian real, -10.6% for the Indonesian rupiah, -9.3% for the Turkish lira, and -6.6% for the South African rand. It is also important to note that these declines are the result of two simultaneous effects: an appreciation of the dollar linked to investors’ need for liquidity and an effect specific to each of the currencies concerned.

– Bond markets have also been very turbulent since then. The GBI-EM (Government Bond Index-Emerging Markets) indices compiled by JP Morgan, which measure the yields offered by emerging market debt in local currencies, are down sharply: -14.5% for Indonesia, -12.9% for Brazil, -10.8% for Turkey, -7% for India, and -6.4% for South Africa. This automatically implies an increase in these governments’ refinancing rates, raising concerns about the sustainability of public debt for the most financially fragile economies, such as India.

– The equity markets are not far behind. The MSCI (Morgan Stanley Capital International) indices are experiencing dramatic declines: -27.3% in local currency (respectively -34% in dollars) for Turkey, -21.2% (-29.6%) for Indonesia, -9.4% (-22.3%) for Brazil, -7.8% (-22.9%) for India, and +1.4% (-5.3%) for South Africa.

Conclusion

In recent years, the ultra-unconventional monetary policies pursued by central banks in developed countries (led by the United States) have enabled emerging economies to offset their trade deficits with large inflows of foreign capital. Following Ben Bernanke’s speech on May 22, 2013, the imminent end of excess liquidity materialized in massive asset sales in emerging countries. This sudden repatriation of capital had numerous repercussions on emerging markets, the most serious being the collapse of their currencies, leading to significant economic and financial imbalances. Furthermore, the tightening of monetary policy in emerging economies seems to have had little (if any) effect in light of fears of an imminent adjustment in the Fed’s asset purchases. In her speech at Jackson Hole on August 23, 2013, Christine Lagarde, the current Managing Director of the International Monetary Fund (IMF), explicitly encouraged emerging economies to intervene directly in the markets in order to « help mitigate exchange rate instability or short-term liquidity pressures. » It was with this in mind that Brazil adopted a number of measures at the end of August 2013. The Brazilian central bank announced a vast program worth $54 billion between now and the end of the year in the form of credit line swaps. Since then, pressure on the real has eased…