Investors have reacted with some alarm to indications that the US Federal Reserve could soon scale back “quantitative easing” (QE). Recent weeks have seen a major sell-off in emerging-market assets as investors anticipate higher returns in the US. This has revived concerns about external financing in some vulnerable emerging markets. Although eventual monetary policy normalisation in the rich world need not be calamitous for emerging markets, many of which have stronger external balance sheets than in the past, vulnerabilities are rising. In addition, recent events may signal a more fundamental reassessment of emerging markets’ economic prospects.
It should be noted at the outset that the sell-off has not solely been the result of US monetary-policy signals, and that its start predated speculation about liquidity withdrawal by the Fed. Lacklustre global economic growth and disappointing data in a number of emerging markets, notably China, but also Brazil and Russia, have contributed to the shift in investor sentiment, as have recent protests in Turkey and Brazil. Nonetheless, the Fed’s change of tone since mid-May has triggered a more dramatic retreat from emerging-market assets. The inevitable process of adjustment, after years of extraordinary monetary accommodation since the economic crisis of 2008-09, will ultimately culminate in higher US interest rates. All else being equal, higher US rates would render emerging-market assets relatively less attractive to investors.
Markets are pricing-in the change in US monetary policy well ahead of the event: even once QE is phased out altogether, the first rise in the Fed’s policy rate target is probably two years away, and in this sense investors are conflating a reduction in the pace of monetary easing with actual tightening—two very different phenomena. The Fed has been at pains to point out the difference, reminding observers that a reduction in its bond purchases under QE would constitute “letting up a bit on the gas pedal” rather than stepping on the brake, to use Fed chairman Ben Bernanke’s motoring analogy. Nonetheless, the mere expectation of a pullback in liquidity has caused market interest rates in the US to rise, rendering concerns about capital flight from emerging markets partially self-fulfilling.
The sell-off has been dramatic. Since May 8th the FTSE All Emerging All-Cap equity index has dropped by 15%. Virtually all emerging-market currencies, barring the Chinese renminbi, have fallen sharply against the dollar. The Brazilian Real, South African rand, Indian rupee and Turkish lira have fallen by 8-11% over the same period. The Indonesian rupiah has come under pressure, contributing to a decision by the central bank to raise interest rates in mid-June. The Mexican peso has also fallen sharply against the dollar (Mexico is one of the most liquid emerging markets, making it a prime target for the sell-off in risk assets). Yields on local and hard-currency emerging-market sovereign bonds have risen sharply.
Key vulnerability factors
Investors are now questioning what the end of the era of easy money could mean for emerging markets. Individual countries’ vulnerability to a sudden reversal of capital flows varies widely, given differences in their macroeconomic fundamentals, external debt profiles and quality of economic management. In broad terms, the economies most likely to come under strain are those that run large current-account deficits and rely heavily on inflows of volatile portfolio investment. This partly explains why Turkey, India and South Africa (with current-account deficits equivalent to 5‑7% of GDP) have been affected by the reversal in sentiment. In these countries portfolio flows, which can be rapidly reversed when investors take fright, play an important role in financing current-account deficits.
In terms of assessing vulnerability, companies seem more likely than governments to encounter funding problems if global liquidity tightens, given the trend in emerging-market debt issuance. In recent years corporate hard-currency debt issuance in emerging markets has overtaken that of governments. Since the start of 2012 alone, emerging-market corporates have issued some US$540bn in bonds—a sum almost equal to the entire outstanding stock of emerging-market hard-currency sovereign debt. The fact that corporate borrowers generally roll over their debt more frequently than governments is an added source of vulnerability.
Many other factors determine investors’ willingness to keep their money in a given country. Turkey, for instance, has been racked by anti-government protests in recent weeks. In South Africa, the fall in the rand partly reflects labour tensions in the mining sector (which threaten exports) and plunging precious-metals prices (although the latter is also linked to the US Fed’s policy stance). Yet in both countries the policy environment is relatively sound. Turkey’s banking sector is well capitalised. It is a potentially different story for countries with more challenging circumstances, such as Ukraine, which is trying to defend a de facto currency peg to the US dollar with very low foreign reserves. Ukraine’s government is resisting energy and exchange-rate reforms that could enable it to access an IMF lending programme. Instead, with economic policy dominated by political considerations, the authorities have been resorting to increasingly quixotic and ad hoc measures, such as the mandatory sale of 50% of exporters’ earnings and limits on cash transactions, in an effort to counter mounting signs of economic imbalance and financial strain.
Stronger balance sheets
Despite the risks that a pullback in Fed liquidity poses, a number of factors should mitigate its impact on emerging markets and make the sorts of currency and balance-of-payments crises of the 1990s less likely. First, emerging-market balance sheets, by and large, are much stronger than they were a decade or two ago, while policy frameworks have improved (including a shift to more independent central banks and floating exchange rates). Many emerging markets have built up substantial foreign-exchange reserves. These offer some protection against balance-of-payments difficulties but remain susceptible to rapid depletion in a crisis. Non-OECD countries’ international reserves have risen from the equivalent of 45% of their external debt in 2000 to 155% in 2012. (The aggregate is, admittedly, inflated by China’s huge build-up of reserves, to around US$3.3trn.) This trend reduces the potential for debts denominated in foreign currency to become unaffordable in local-currency terms. Many emerging markets have, in any case, become less dependent on foreign-currency borrowing by encouraging the development of local-currency funding markets.
A second mitigating factor is that the ultra-low-interest-rate environment engendered by QE in the rich world has enabled some emerging-market governments and corporates to pre-fund their needs by issuing debt at attractive rates. Recent rises in bond yields will make this more difficult and costly, but in retrospect those that did borrow before the market sell-off—including a number of governments and corporates in Latin America—now look quite savvy.
Thirdly, markets’ negative reaction to the prospect of QE “tapering” ignores the fact that any withdrawal of liquidity will be gradual and cautious, and that monetary-policy normalisation by the Fed implies an improvement in the US’s economic fundamentals that should benefit the rest of the world through increased trade and investment.
A pro-cyclical sting in the tail?
Yet while emerging markets are generally in a better position to withstand a global reallocation of assets than they were in the 1990s or 2000s, this does not mean that the adjustment will be smooth or that the absence of balance-of-payments problems will preclude difficulties of other sorts. Whereas the US Fed is rightly seeking to engineer a carefully planned and signalled exit from QE, abrupt and reactive policy adjustments may prove unavoidable for some emerging-market central banks if the asset sell-off continues. Brazil and Turkey have both tightened monetary policy recently, partly in an effort to relieve downward pressure on their currencies. Further tightening is almost certain in Brazil, given building inflationary pressures, and a possibility in Turkey. Yet such moves would be pro-cyclical given relatively weak economic conditions in both countries, and higher interest rates could choke off recovery. Compare, for example, Turkey’s situation with that in 2011, the last time there was a run on the Turkish lira and the central bank had to raise interest rates to attract capital inflows. At that time the economy was growing at about 9% a year. Now growth is about 3%.
Other potential disruptions abound. Brazil, for instance, has abandoned a financial transactions tax previously implemented in an attempt to stem appreciation of the Real. Given concerns over the government’s increasingly interventionist and statist policy model, this sudden U-turn—although welcome in removing a distortionary capital control—could reinforce foreign investors’ impressions of policy unpredictability. Currency weakness in a number of other Latin American economies is largely welcome for now, but continued depreciation, if coupled with higher inflation, could push monetary policy in directions not fully warranted by domestic fundamentals. Colombia’s central bank has already halted monetary easing, in part because of recent developments in global markets. In Mexico, a weaker peso might well encourage the Banco de México (the central bank) to hold off from cutting interest rates, despite tepid economic growth.
Bigger questions
Financial-sector skittishness may also mask more fundamental concerns. The growth outlook for emerging markets has darkened as data from China, in particular, have disappointed in early 2013 and as it has become clear that the world’s second-largest economy is undergoing a secular shift towards slower growth. A recent surge in interbank rates has hardly helped, fuelling fears about a financial crisis in the largest emerging market following years of rapid credit growth. The Economist Intelligence Unit is still relatively positive about overall emerging-market prospects. We forecast that aggregate GDP growth in non-OECD countries will accelerate from 4.7% in 2012 to 6.3% in 2016 as the global economy improves. Yet challenges loom, and policymakers may have to tackle them at the same time as a global shift in liquidity is under way. In recent years abundant liquidity has boosted emerging-market economies and financial markets, both by helping to prevent steeper downturns in the developed economies with which emerging markets trade and by suppressing yields on bonds in the rich world, thereby encouraging money to be channelled to developing countries. The start of the end of easy money is not yet here, but markets are starting to price it in—in prospect is a widespread reappraisal of emerging markets’ ability to sustain recent growth rates once monetary conditions in the advanced economies normalise.
