1 November 2013
Emerging markets from Latin America to Southeast Asia breathed an audible sigh of relief when the US Federal Reserve – contrary to most market expectations – refrained from initiating its much anticipated policy of "tapering" at its last FOMC meeting in September. Tapering would have in essence signaled the beginning of the end for the Fed's extraordinary and unprecedented stimulative effort known as Quantitative Easing. Through its monthly purchases of $85 billion in securities, the Fed has been pumping massive amounts of capital into the economy and keeping interest rates near zero – all in effort to spur economic activity in the sluggish post-global financial crisis environment.
The implications of QE, however, have been felt far beyond the shores of the US. Much of the capital pumped out by the Federal Reserve has ended up in emerging markets, in search of higher rates of return. Equity markets and various asset classes – real estate, in particular – have surged, especially in key growth markets in Southeast Asia. "Easy money" from the US has funded everything from condo developments and shopping malls, to generous government programs paid for with a credit card.
Tapering would mean that this "easy money party" would soon be winding down. Indeed, even the mere prospect of tapering, as hinted at by Fed Chairman Ben Bernanke in May, was enough to cause equity markets and currency valuations in many emerging markets to swoon over the summer, as capital retreated back to the US in anticipation of higher interest rates.
When the US Federal Reserve, contrary to expectations, refrained from announcing the onset of tapering in September, the slide in emerging markets immediately began to abate. This reprieve –and the accompanying return of confidence – was further bolstered by two additional developments:
President Obama had been weighing candidates to succeed Ben Bernanke as Fed Chairman when his term expires in early 2014. The two acknowledged front-runners to take the helm were Larry Summers, former Treasury Secretary and a key economic advisor in both the Clinton and Obama Administrations, and Janet Yellen, a well-respected academic and the current vice-chair of the Fed.
Of these two, Yellen was seen as being much more likely to maintain the QE program and refrain from any significant near-term tapering. Summers, on the other hand, was seen as more likely to initiate tapering sooner and more aggressively. When Yellen ultimately emerged as the designated successor to Bernanke, the sense of relief in emerging markets was palpable.
This sense of relief was further bolstered – perversely enough – as a result of the calamitous political gridlock in the US over the budget and the debt ceiling, which raised the possibility of a US default and a severe global economic downturn. With these issues lingering on without a definitive long-term resolution, storm clouds have continued to hang heavy in the air, as a return to the precipice a few months hence cannot be entirely ruled out.
With the global economy in such a fragile condition, the conventional wisdom is that the Fed would be highly unlikely to commence tapering any time soon, for fear of tipping the scales towards recession.
All of these factors have served to alleviate the immediate sense of urgency felt so acutely during the summer months over the potential impact of tapering on emerging markets. But any sense of relief should be tempered by a more sober-eyed view: The day of reckoning has only been postponed – not avoided. Tapering almost certainly will begin sometime in 2014.
Complacency and a false sense of security should therefore be avoided. The emerging market turmoil over the summer provided clear and unambiguous "coming attractions" of what can be expected when tapering actually does commence -- as it inevitably must. The temporary reprieve now being enjoyed should be used as an opportunity to fortify the roof before the rainy season starts.
Who will be most vulnerable when tapering does in fact commence? Those countries with large current account deficits, less than abundant foreign currency reserves, and generous government programs funded by deficit spending.
Quantitative Easing has enabled countries to run trade deficits by providing the capital needed to bridge the gap between imports and exports. Generous government programs, often undertaken for political as much as economic reasons, have also been enabled by access to plentiful and cheap capital, as ultra-low borrowing cost have allowed governments to engage in aggressive deficit spending.
The time to start addressing these issues is now; not when decreasing access to low cost capital removes any choice. Attention to trade and budget deficits is especially important.
In Southeast Asia, Indonesia is the country probably most in need of heeding this advice, but by no means the only. On a global basis, Morgan Stanley has identified what it refers to as the "Fragile Five", i.e. countries that will be in most immediate danger when tapering begins: Brazil, Indonesia, South Africa, India, and Turkey.
Although it will not happen as soon as previously expected, the Quantitative Easing "party" will soon be drawing to a close. Emerging markets should begin now to take actions to minimize the "hangover".