September 14, 2013
Summer was marked by a strong pressure of capital outflows and exchange rate devaluations in several systemically relevant emerging markets. A global portfolio rebalancing was put in motion on May 22, when talk of the U.S. Federal Reserve shrinking — and eventually reversing — its asset purchase program (QE or quantitative easing) was made public.
The global portfolio adjustment — away from countries/markets deemed as vulnerable to QE unwinding and toward those whose prospect improvement has justified a possible future policy change — follows a previous dramatic financial movement that was in the opposite direction. Gloomy prospects for advanced economies (ACs) in the Post-Lehman era, the Eurozone crisis, the several channels of transmission of QEs, and the post-2008 aftershock resilience of emerging markets (EMs), together led to a massive capital de-location — and use of leverage capacity — from ACs to EMs. By all accounts, the increase in assets and exposure to EMs from 2009-2012 was tremendous, despite the presence of capital controls and other measures adopted by recipient countries.
Therefore it is not surprising that the expectations channel of transmission of monetary policy — after the announcement of a future “tapering” of Fed’s asset purchases, to be followed by an eventual shrinkage of Fed’s balance sheet — was enough to spark a meaningful wave of portfolio rebalancing. News on growth slowdown in major EMs also mattered. However, the May 22 announcement from the Fed, signaling some confidence in the U.S. recovery, and an immediate uptick on 10-year Treasury bond rates, triggered a massive unwinding of long positions on EMs. This was particularly sharp in emerging markets with current-account deficits, prone to undergo exchange-rate devaluations. Given the magnitude of previous flows, it is no wonder there seemed to be mayhem with the current global portfolio realignment.
The effects of the announcement of a “tapering” — reduction at the margin — of monthly asset purchases by the Fed immediately started to be felt, even though its date start was yet to be established. Will U.S. long-term Treasury yields skyrocket when the Fed begins to shrink its balance sheet toward more “normal” levels and make the current turmoil look like a walk in the park?
Not necessarily so, for two reasons: first, one may say that the Fed’s balance sheet expansion has not been much greater than the world’s demand for money. The evolution of 10-year Treasury yields along the quadrupling of the US monetary base does not point out to the Fed systematically pushing for abnormally low 10-year yields. There is ground to believe that the Fed mostly accommodated the private (bank) demand for “excess reserves.” Therefore, one might expect that, provided that the US economic recovery settles in and the private demand for long-term bonds normalizes, the Fed will not have to dump unwanted assets on the market and, thus, offer huge discounts and high interest rates. There is no reason for the Fed to risk derailing the economic recovery by not following such a path.
This leads us to the second reason for not expecting skyrocketing interest rate. There is no sign of an uptick on U.S. inflation rates or expectations and, therefore, no need for substantial interest rate hikes in the foreseeable future. Interest-rate policies could conceivably be separated from the unwinding of the balance-sheet expansion, but the fact is that the U.S. economy is likely to remain on a low-inflation environment for some time.
Emerging markets are not currently as vulnerable as they were in previous moments of global interest rate hikes. Current exchange rate devaluations reflect the adjustment flexibility embedded in their currency regimes, as opposed to pegged rates which in the past made EM currencies sitting-ducks for speculative attacks. Furthermore, reserve cushions are much larger, both corporate and public-sector debts in most EMs are not as fragile as they were on the brink of the 1990s crises, and the proportion of equity-like investment and domestic currency-denominated debt is higher. Though policy responses will be challenging, apart from some vulnerable spots, there is more policy space to react to the challenges created by the global portfolio realignment.
While unconventional monetary policies have been appropriately anti-cyclical in ACs implementing them, they have had inappropriately pro-cyclical consequences on EMs — boosting credit and demand when most economies among the latter were already heated up, and threatening to accentuate a slowdown where it started to happen. It is also true that, regardless of the role played by the liquidity wall flooding EMs, these countries have in general been too complacent regarding structural reforms necessary for the exploitation of new growth opportunities. All in all, unwinding QE policies may ultimately be good news for EMs, especially if the withdrawal of global liquidity is followed by a sharpened focus on their country-specific reform agendas.