QE Phase Out as a Stress Test for Emerging Market Economies

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Tomislav Cvetko's picture

            Fed’s initiative to phase out the quantitative easing is undoubtedly going to influence the financial and economic environment, in the same way as its implementation several years ago fueled major changes in the financial and social structures, both in the United States and its trading partners. The question remains, however, to which degree is this monetary policy action going to influence economies and financial markets around the world – are they going to end up in a complete financial distress or will they continue without major scratches? The problem has to be approached from two separate aspects, one of which is more logical, predictable and expected, while the other one accounts for increasing unpredictability of markets and investors, thus trying to take Keynes’ animal spirits into consideration.

            Namely, first perspective would be covering the main indicators of economic and financial stability, including the GDP growth rate, current account balance, unemployment rate, exchange rate fluctuations and stock market indices, as well as the expected changes they might undergo as the tapering begins. Evidently, the Fed will start with the phase out once it feels that the U.S. economy is strong enough and well on its path to stable recovery, based on those key indicators, while also taking the time lag of the monetary policy actions into consideration. As far as its trading partners are concerned, they should find a way to cement their economic stability regardless of the U.S. monetary policy actions by the time tapering starts, otherwise their key economic indicators might plummet immediately.

            On the other side, second perspective puts more emphasis on the studies of behavioral finance, which contemplates about the anticipated investors’ reactions, once the Fed begins with the phase out of quantitative easing. It takes into consideration the likelihood of economic and social unrest occurring in the (still) relatively unstable emerging markets, as well as reoccurrence of some of the situations that some of them faced in the close history – speculative attacks on the local currency, massive capital withdrawals and the crash of the local stock market. Finally, combining these two perspectives, it is possible to develop a model that highlights three different stages, or checkpoints, which could serve as indicators of those countries that will overcome tapering and those that might crumble under pressure, assuming they welcome Fed’s monetary policy changes unprepared.

            The focal point of the first step in this model would be addressing the slowdown of economic growth that is expected as the consequence of QE phase out, as well as solving the problem of large deficits in the country’s current account. If one feels comfortable that the country has developed alternative sources of economic growth aside from those based on the cheap capital inflow provided by the Fed’s quantitative easing, then the country’s stability shouldn’t be questioned. Countries that would not pass the first step of the evaluation are faced with an even greater problem, as they move to the second step of the framework. This includes massive capital withdrawals, as dissatisfied and discouraged investors escape the markets that didn’t seem to prepare well enough for the new environment, and cannot offer anything attractive once the cheap funds have dried up. At this point, above-mentioned second perspective takes over, as investors’ perception starts playing more important role than country’s key indicators. Lastly, the third step of the model is solely based on the behavioral finance elements, as enormous local currency pressures, generated by constantly increasing supply of domestic currency from foreign investors, force the central banks to spend their foreign reserves and even open a legitimate opportunities for speculative currency attacks. Major currency devaluation would consequently destroy the purchasing power of the local population and cause major economic, political and social unrest.

            Unfortunately, some of the emerging market countries are very familiar with these situations, and this should be a strong test of whether they improved their financial infrastructure or were they just riding on the waves of fortunate economic environment that allowed them to generate double-digit growth rates over the recent years. Now that the framework for evaluating the countries’ potential to avoid the negative consequences of Fed’s tapering has been established, it is possible to reasonably assume the likelihood of economic instability arising in certain markets. The following analysis will concentrate on the buffer that the country has built, or might build in time to tackle the negative consequences of QE phase out in each of the three elements elaborated in the previous section.

            Based on the previously presented parameters, one can hardly argue that United States will be severely impacted by the Fed’s tapering. As Conerly (2013) pointed out, the impact of the latest installment of the Fed’s quantitative easing hasn’t had a significant impact on the U.S. economy, although the lag with which monetary policy actions influence the real sector can be quite substantial, so the final remarks cannot be made yet. However, it is safe to assume that the multiplier effect was very low in the case of the United States. Conerly (2013) questions whether any impact would be seen in the key economic indicators of the United States, should the Fed start with the phase out of the quantitative easing at this moment. Obviously, all of the arguments state that the U.S. economy would safely pass the first step of the above-mentioned framework, thus leaving no room for the potential development of the economic and financial instability once tapering begins.

            The picture looks significantly different, as we start shifting our focus towards the trading partners of the U.S., where the special attention will be on the emerging market countries. As Schaefer (2014) claims, investors apply different rules as they approach financial markets within the developed countries and those in the emerging countries. Most notably, the fluctuation of the capital is a lot more dynamic in the emerging markets, which explains their massive success during the monetary policy expansion by the Fed, as well as the reason why investors started looking doubtfully at these countries once Fed made tapering plans public. It is now clear that the majority of emerging markets simply lacked the proper incentives to invest both time and resources to establish stable financial environment, as they mainly focused on the short-term growth fueled by the easily accessible capital and risk-prone investors looking for high-risk-high-return investment opportunities.

            In this environment, public quickly forgot that less than twenty years ago, some of these countries were hit by strong crises, such as East Asian crisis, Russian turmoil or Brazil’s currency crisis, just to name a few. Since then, these countries failed to develop strong building blocks for the sustainable growth and instead relied on the favorable investment climate. In his article, Soto (2013) emphasizes how easy it is to get used to constant liquidity. As this liquidity dries out, however, poor economic indicators of the emerging market countries will be exposed (Schaefer, 2014). This is the reason why most of them already have to start contemplating about the possible solution to the second step of the framework – how to prevent massive capital outflows, as they already missed the opportunity to settle the first step. Jelmayer (2014) states the intention of some countries to start building the buffer right now, yet most of the damage has already been done in the eyes of the investors.

            In case investors really decide to rapidly flee one of the emerging market countries, it will be up to its central bank to prove that they have learnt from the lessons of the 1980’s and 1990’s, as their foreign reserves will be tested by the speculators looking for spectacular earnings – third and last step in the framework presented in the introduction. Even if this series of events doesn’t result in a full currency attack, it seems that some type of currency depreciation is unavoidable. As it frequently is the case in the emerging markets, politicians frequently try to settle the social and political unrest resulting from decreasing purchasing power of the local population through various populist measures, as they become concerned about their next mandate – Turkey can be taken as a prime example (Evans-Pritchard, 2013). Clearly, these actions would further propel the lack of fiscal policy discipline, thus contributing to growing instability and increasing country’s debt burden.

            Without doubt, most of the emerging markets will be (and already are) seriously threatened by the Fed’s tapering, mostly because they lacked incentives to finally establish a stronger financial and monetary environment, as well as finding alternative sources of growth that are not based on the inflow of easily accessible and cheap capital coming from the United States, thus relieving themselves of the constant dependence on the U.S. policy changes. Until this changes, it is extremely likely that we will witness yet another financial meltdown, resulting in not only financial, but overall economic instability, with country’s citizens again being the most exposed victims.


Conerly, B. (2013, December 18). Fed’s Taper Will Have Negligible Impact on Economy. Forbes. Retrieved from http://www.forbes.com/sites/billconerly/2013/12/18/fed-taper-not-changin...

Evans-Pritchard, A (2013, December 27). Turkey first of Fed Taper victims as political crisis scares investors. The Telegraph. Retrieved from http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/105397...

Jelmayer, R. (2014, January 24). Brazil’ Central Bank President Says Monetary Policy Is Working. The Wall Street Journal. Retrieved from http://online.wsj.com/news/articles/SB1000142405270230463220457934041082...

Schaefer, S. (2014, February 3). Why Panic-Prone Emerging Markets Are Breaking Down in 2014. Forbes. Retrieved from http://www.forbes.com/sites/steveschaefer/2014/02/03/why-panic-prone-eme...

Soto, A. (2013, October 13). Analysis: Late Fed taper may do more harm than good for emerging nations. Reuters. Retrieved from http://www.reuters.com/article/2013/10/13/us-g20-emerging-fed-analysis-i...