In December 2008, the FOMC reduced the federal funds rate to the range of 0 to 25 basis points and subsequently encountered the lower bound problem. (Bernanke, 2012) As the economic situation continued to deteriorate, the Fed had to turn to non-traditional policy approaches in an attempt to achieve its dual mandate of maximum employment and price stability. In particular the Fed chose to implement quantitative easing (QE).
As the recovery picked up, Fed Chairman Ben Bernanke first hinted at a possible taper in June 2013. The resulting turmoil in emerging market currencies certainly indicated that the Fed’s exit from unconventional monetary policy risked pushing these trading partners into a bout of instability. QE had put downward pressure on US interest rates which encouraged investors to look abroad in a search for yield. Hence the taper implies a gradual increase in US yields and subsequent reduction in the demand for emerging market assets. Essentially, as capital starts to moves out of EMEs (emerging market economies), their currencies will depreciate. This is important when one considers that turmoil in financial markets inevitably spills over into the real economy, as the global financial crisis so clearly illustrated.
The past two months have shown that the Fed was indeed unable to phase out QE without causing disruption in some of its EME trading partners, notably Brazil Mexico and India. However, the US economy and many of its other key trading partners (such as Canada, Germany, France, and the UK) have avoided any real taper related instability. (US Department of Commerce)
Historically, EMEs have suffered when US yields have risen and the dollar appreciated. The 1997-8 EM crisis was primarily due to what Panizza et al (2003) coined ‘Original Sin’; the inability of emerging markets to borrow in their own currency. This left them exposed when their currencies came under pressure. As Credit Suisse analysts explain, EMEs as a group now have the capacity to prevent a repeat of the late 1990s. (The Financialist, 7 February 2014) Today most EMEs have flexible exchange rates and deep local markets that act as fundamental funding tools if international finance tightens. (The Financial Times, 12 January 2014) Furthermore, their current-account deficits are smaller: ‘only two of the 25 emerging markets tracked by The Economist have a deficit above 5% of GDP’. (The Economist, 1 February 2014) While this may be true of the group as a whole, US trading partners India, Mexico and Brazil remain exposed. The reason being, the US taper is not the only factor behind the recent turmoil in these countries. As the cost of capital normalizes, issues beyond the control of the FED (such as the latest form of Original Sin, softer commodity prices, and political upheaval) pose a threat to these trading partners.
The phenomenon Original Sin comes in various forms, and thus cannot be considered to have fully receded. In June 2013, Morgan Stanley talked of the more recent manifestation of Original Sin; the dramatic increase in foreign holdings of local bonds in some EMEs as a direct consequence of capital inflows. (Morgan Stanley, 13 June 2013) In 2013, international investors controlled 46% of the domestic government bond market in Mexico, 63% and 46% in Brazil. (Morgan Stanley, 13 June 2013) High levels of international money in local markets means these countries remain highly vulnerable to capital outflows.
Graph 2 and 3 (Source: Morgan Stanley, 13 June 2013)
The second big issue for EMEs at present is the political uncertainty surrounding reforms. Years of credit growth allowed some EMEs to hide economic instabilities. For example, Morgan Stanley estimates that half of India’s $225bn corporate bonds are unhedged, due to the dollar’s long weakness leading to financial governance complacency. (The Financial Times, 12 January 2014) As the cost of capital now normalizes, these countries must deliver on key reforms to deal with such issues. In India, the introduction of reform is seen to hinge on the elections in May. If the party voted into power has to form a coalition with smaller parties, there is a fear that some states will continue to be controlled by opposition parties which could stall reform. (The Business Insider, 27 January 2014)
Some EMEs have relied too heavily on China’s export-driven growth model. (Morgan Stanley, 6 February 2014) China is now embarking on reforms to move from export-driven to a consumption-driven growth. This could bring GDP growth rates down to 5%- 7%, compared to the last decade’s 8%- 10%. Indeed, China’s Purchasing Managers Index Survey for January indicated a slowdown in the pace of expansion in China's services sector over the past month, falling to 53.4 from 54.6. Given its importance as a commodity consumer, weaker Chinese growth may put commodity currencies such as the Brazilian Real under severe pressure. (Morgan Stanley, 23 January 2014)
While we now know that the Fed couldn’t phase out QE without triggering volatility in some of its trading partners, the question remains as to whether this instability will persist or indeed worsen going forward. This is very much down to EMEs themselves and their capacity for reform and monetary adjustment as the Fed exits from QE. In this regard, the outlook so far seems positive. EME policymakers have been proactive in pushing reform. For example, the Central Bank of India, who had taken its eye of inflation, is now moving towards an inflation target. (The Economist, 1 February 2014)
In terms of the outlook for the US, the phasing out of QE has not caused severe domestic financial or economic instability. Many had worried that once the Fed removed the exceptional support it was providing to both the stock and bond markets we would see a sharp correction in financial markets. (Economist, 8 February 2014) Notably however, the initial reaction to the taper in December was in fact positive. We saw that the market rallied on the basis that the winding down of QE signalled strong US recovery and improved future prospects. (The Financialist, 17 December 2013) While there has been some correction in equity prices so far in 2014, we have yet to see any dramatic readjustment following the taper. Certainly the gradual pace of the taper plays a key role in this regard. (The Financialist, 13 December 2013) The expected pace of $10bn at a time means tapering will be drawn out over the course of 2014, so as to wean the market off this exceptional monetary policy measure.
Additionally, on the basis of the expectations hypothesis, forward guidance about the future path of the federal funds rate should keep downward pressure on longer term rates. When they began the taper programme the Fed stated that the unemployment rate would have to decline below the 6.5% threshold before it would consider raising the federal funds rate. (The Federal Reserve, 2014) This guidance has recently been updated as the 6.5% threshold is approached; unemployment fell to 6.6% on 7 February. The Fed plans to keep rates low even after the 6.5% target is reached. The January FOMC report, which was almost identical the December report, de-emphasised the threshold and re-affirmed that 6.5% is not a trigger. The FOMC members have recently downplayed the significance of the unemployment threshold, linking the rate less to buoyant demand for labour than to stagnant supply, as discouraged workers stop hunting for jobs. (The Economist, 15 February 2014) In her inaugural address on February 11th, Janet Yellen called the recovery in the labour market ‘far from complete’. (The Economist, 15 February 2014)
Stability in the financial markets will certainly have positive spill over effects for the real economy. Economic recovery prospects are also helped by projections for Shale Gas production in the US. (Credit Suisse, 1 October 2013) While we have seen some discrepancy in the economic indicators (a weak US payroll and manufacturing numbers for example) Credit Suisse, amongst others, considers that the US economy will grow at a rate of 3% this year. (The Finanicialist, 7 February 2014)
The taper is yet to cause severe instability in either their financial market or economy of the US’ main trading partner, Canada. Nor has it explicitly affected the US’s more developed trading partners. Providing oil transport bottlenecks do not prevent the US recovery supporting Canada’s exports, Canada is positioned to gain from the US recovery. (Morgan Stanley, 9 January 2014) The economic recovery in the UK looks particularly promising, with the Bank of England expecting the UK to reach 3.4% GDP growth in 2014. In fact the strong performance of the UK has forced the BOE to shift the focus of their forward guidance policy from the unemployment rate to a broader measure of economic health (‘spare capacity’ in the economy for example). (The Economist, 12 February 2014) In terms of the Eurozone, despite the low level of inflation (0.7%), Draghi also remains positive about EU recovery. Following the ECB meeting in February, Draghi insisted that the Eurozone is not threatened by Japanese like deflation, and thus left interest rates unchanged for the time being.
As tapering signals a recovery in the US, which is obviously good for global trade, one would expect that it is unlikely to result in any prolonged instability in either the US or its trading partners. Indeed, going forward, the bout of EME instability following the first two rounds of the taper should subdue to the general positive spill over effects of the taper.
Bibliography Ben Bernanke, ‘Monetary Policy since the Onset of the Crisis’ (August 31, 2012) (http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm) Credit Suisse, ‘The Shale Revolution II’ (1 October 2013) Eichengreen, Hausmann, Panizza, ‘The Pain of Original Sin’ (2003) Morgan Stanley, ‘Emerging Markets: What if the tide goes out?’ (13 June 2013) http://www.btinvest.com.sg/system/assets/15223/EmergingMarkets_BP061313.pdf Morgan Stanley, ‘FX Pulse’ (23 January 2014) (http://www.morganstanley.com/institutional/research/pdf/FXPulse_20140123...) Morgan Stanley, ‘FX Pulse’ (6 February 2014) Morgan Stanley, ‘FX Pulse’ (9 January 2014) The Business Insider, ‘The Fragile Five’ (27 January 2014) (http://www.businessinsider.com/heres-how-the-fragile-five-are-doing-2014...) The Business Insider, ‘Too Many Fires Burning’ (27 January 2014) (http://www.businessinsider.com/why-emerging-markets-are-tanking-2014-1) The Economist, ‘Emerging Markets: Don’t panic’ (1 February 2014) The Economist, ‘Emerging Markets: Locus of extremity’ (1 February 2014) The Economist, ‘Forward Guidance: On to the next phase’ (12 February 2014) The Economist, ‘Turmoil in Financial Markets: Goldilocks and the three bears’ (8 February 2015) The Economist, ‘Unemployment in America: Closing the Gap’ (15 February 2014) The Federal Reserve, ‘December FOMC Report’ (18 December 2013) (http://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm) The Federal Reserve, ‘January FOMC Report’ (29 January 2014) (http://www.federalreserve.gov/newsevents/press/monetary/20140129a.htm) The Financial Times, ‘Investment: dollar disruptions’ (12 January 2014) (http://www.ft.com/intl/cms/s/2/9b50c6a4-34c1-11e3-8148-00144feab7de.html...) The Financialist, ‘Here comes the Taper’ (13 December 2013) (http://www.thefinancialist.com/here-comes-the-taper/) The Financialist, ‘The Greenback Bull Market is Coming’ (17 December 2013) (http://www.thefinancialist.com/the-greenback-bull-market-is-coming/) The Financialist, ‘Emerging Markets: it’s still not a crisis’ (7 February 2014)
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