On September 18, 2013, the US Federal Reserve (Fed) surprised the world by deferring the planned winding down of its quantitative easing (QE) program. The announcement brought some respite to capital, currency, and commodity markets across the globe. Since May, when the Fed first hinted at a gradual winding down of QE starting later this year, markets have been hit by sharp capital outflow from emerging economies, rising interest rates, and uncertainty about the impact of QE tapering on US economic growth. Emerging economies have been the worst-affected, especially those with large current account deficits, high external borrowings relative to reserves, and weak public finances.
Ominously, the sharp fall in currency and capital markets in emerging economies has provoked comparisons with the Asian financial crisis of the 1990s. Economists worry that a swift tapering by the Fed could produce a similar scale of fund outflow from emerging economies, impacting banking sector health, currency stability, and the wider economy. Although some of these concerns are well founded, the situation today is different from the 1990s. Economies now have larger foreign reserves, better capital controls, and lower banking sector risks with less exposure to external wholesale funding.
Policymakers in emerging economies have also proactively countered the current dip in currencies, equities, and bonds. Luckily for them, the Fed’s latest decision will give them a bit more time to fine-tune policy, but they might encounter higher volatility in the short term due to uncertainty over tapering. Nevertheless, with long-term growth prospects still strong, the current adversity will hopefully nudge these economies to focus more on reforms aimed at enhancing competitiveness and removing structural bottlenecks.
Economies now have larger foreign reserves, better capital controls, and lower banking sector risks with less exposure to external wholesale funding.
Emerging economies’ face-off with QE: Not a new phenomenon
Having to bear the brunt of the Fed’s announcement in May, central bankers in emerging economies have urged the Fed to be cognizant of global implications before enacting any change to its current asset purchase program. Ironically, this is not the first time that emerging economies are seeking greater cooperation from the Fed. In 2009–2010, after the Fed’s launch of QE, emerging economies witnessed a flood of inflows of cheap money. This propped up equity, currency, and bond markets in these economies (see figures 1 and 2). In some economies, money flowed in despite lower growth prospects and structural deficiencies. For example, in 2009, the Brazilian real appreciated by almost 36 percent, and the equity market nearly doubled even though real GDP fell 0.3 percent, compared to growth of 5.3 percent in 2008. In fact, the real continued to appreciate against the greenback well into 2010, prompting the country’s finance minister to accuse the Fed of unleashing a currency war.
Figure 1. Emerging economies’ currency returns versus the US dollar since the start of QE till early 2013
Figure 2. Emerging economies’ equity index returns since the start of QE till early 2013
Impact of the Fed’s hint of tapering on emerging economies
Speculation about a possible tapering by the Fed has propped up interest rates in the United States, thereby reducing the yield differential on debt instruments that emerging economies were enjoying before the announcement. At the same time, improving economic data in the United States have ensured that equities there have outperformed their emerging-market counterparts. This has paved the way for a reverse flow of funds back into the United States. No wonder then that the Fed’s statement in May has led to a hammering of emerging market currencies, stocks, and bonds (see figures 3, 4, and 5). For example, by September 1, 2013, the Indian rupee and the Brazilian real had fallen by more than 15 percent each since the Fed’s announcement in May. In equity markets, Indonesia’s Jakarta Composite Index and Turkey’s BIST 100 shed nearly 20 percent each during this period. In debt markets, 10-year government bond yields in Turkey have shot up by nearly 370 basis points (bps) since May 1; the corresponding rise in Indonesia was about 290 bps.
It is noteworthy that for a number of emerging economies, including South Africa, Turkey, and India, much of the current turmoil is also due to deterioration in economic fundamentals, primarily high current account deficits, entrenched inflationary pressures, and deteriorating public finances. Concerns about the Fed tapering off can be considered a trigger for the outflows, but not the sole reason for them. However, the impact of tapering concerns extends even to economies with relatively better fundamentals. For example, the Philippines, which has better growth prospects, public finances, and external position, has taken a significant hit to its currency, equity market, and bond yields. From May 1 to September 1, 2013, the peso depreciated 8 percent, stocks fell 16 percent, and 10-year government bond yields went up 28 basis points.
It is noteworthy that for a number of emerging economies, including South Africa, Turkey, and India, much of the current turmoil is also due to deterioration in economic fundamentals, primarily high current account deficits, entrenched inflationary pressures, and deteriorating public finances.
Definitely not a rerun of the Asian financial crisis
The sudden dip in emerging market currencies, equities, and bonds have led some to draw parallels with the Asian financial crisis of 1997 when Indonesia, Malaysia, Philippines, and Thailand saw their currencies plummet with massive capital outflows. The crisis left these economies tending to scores of bankruptcies and requiring bailouts from the International Monetary Fund. A repeat of such a crisis will be debilitating to the global economy, especially when it is still recovering.
But is the situation today really as dire as in 1997? It would appear not (see figures 6–9). Compared to the 1990s, emerging economies today hold nearly five to ten times more foreign exchange reserves, giving them substantial resources to protect their currencies. In addition, countries at the heart of the crisis in 1997, including Malaysia, Philippines, and Thailand have vastly improved current account balances, which place them in a position of strength. Significantly lower levels of external debt also bolster the countries’ standing. Furthermore, the banking systems of most major emerging economies are more robust today and more likely to withstand shocks. Hence, it may be safe to say that we will likely not witness a repeat of the Asian financial crisis. However, pockets of concern remain such as the wide current account deficits and external debt positions of South Africa and Turkey. India too needs to bridge its yawning current account gap.
Leaving no stone unturned to shore up currencies
Central banks have stepped in aggressively to dent sharp currency depreciation and thereby counter imported inflation. The central banks of Brazil, India, and Indonesia have raised their respective policy interest rates (see figure 10). Countries are also pressing their foreign exchange reserves to action. For instance, India is selling dollars via swap agreements to major state-owned petroleum importers. In August 2013, Brazil also announced a $60 billion currency intervention program involving swaps and repurchase agreements with businesses requiring dollars. Bilateral currency swap agreements with frequent trade partners are also being explored. In September, India identified seven emerging economies with whom it plans to trade in rupees. Indonesia is also trying to establish two swap agreements worth nearly $30 billion and may extend an older agreement with China.
India and Indonesia are also cutting imports to stem their current account deficits and boost their currencies. India aims to lower its gold imports bill by hiking duties. Indonesia has targeted luxury car imports and is mandating higher biodiesel usage to cut oil imports. In addition, policy changes to boost FDI and boost exports are also being used. For example, Indonesia has announced tax incentives for investments in agriculture and metal. India is seeking to encourage FDI by easing restrictions in key sectors like telecommunications. In addition, India has increased deposit rates on select dollar-denominated deposits for Indians residing overseas. Brazil and India are also attempting to boost their respective currencies through changes in capital controls. In June 2013, Brazil removed several capital controls, including taxes on foreign portfolio investments. India, on the other hand, restricted overseas investments by Indian companies and citizens beginning mid-August.
Meanwhile, just sitting the storm out appears to be another option, at least for Turkey and South Africa. Turkey’s central bank has sold $6–8 billion in foreign currency auctions since June 2013, but it has not been able to substantially stem the lira’s fall. Hence, it is likely that it will pause for a while. South Africa’s central bank, on the other hand, has mostly maintained a non-interventionist approach, favoring a market-determined exchange rate. However, there is a step that even South Africa is taking to shield the rand from a long-term perspective. In September, South Africa joined Brazil, Russia, India, and China in plans to establish a $100 billion foreign exchange fund, which will likely begin operations by 2015. Members may be able to draw a specified amount from the pool to stabilize their currencies. The efficacy of such a fund remains to be seen, given a similar fund established by the Association of Southeast Asian Nations, China, Japan, and South Korea in 2010 has not yet been drawn upon.
Figure 10. benchmark interest rates in 2013 (%)
The delay in tapering provides a breather to the emerging economies, acknowledged by the immediate exuberance of equity and currency markets.
Darkest before dawn
In view of the Fed having deferred the tapering, perhaps by a few months, the impact on emerging economies will be interesting to note. The delay in tapering provides a breather to the emerging economies, acknowledged by the immediate exuberance of equity and currency markets. However, soon after, stock markets and foreign exchange rates returned to trend, affirming that fundamental factors related to the individual countries will still drive currencies, equity markets, and bond yields (see figures 11 and 12).
Policy challenges, high inflation, wide current account and fiscal deficits, and slowing growth are challenges that may discourage foreign investments in markets such as Brazil, India, South Africa, and Turkey, irrespective of the Fed’s latest action. In addition, given the Fed’s decision in September not to start tapering, anticipating the timing of a future move by the Fed will increase volatility and uncertainty. Furthermore, with valuations in less risky equity markets of Europe looking attractive, fund flows into emerging economies’ equities may remain adversely affected in the short term (see figure 13).
However, long-term prospects for emerging economies remain attractive, as growth rates are expected to exceed those of the United States and other major developed economies (see figure 14). As a result, funds are expected to flow back to emerging economies in the medium term. Moreover, with the Fed making it clear that its actions will be governed by US interests only, it may be just the trigger for some emerging economies to wake up from their policy slumber and move ahead with critical reforms to restore economic confidence.
Figure 14. Emerging economies’ real gdp growth (%) will surpass developed economies
Policy challenges, high inflation, wide current account and fiscal deficits, and slowing growth are challenges that may discourage foreign investments in markets such as Brazil, India, South Africa, and Turkey, irrespective of the Fed’s latest action.