US monetary policy is an unlikely threat for Emerging Markets
By Dr. V. Anantha Nageswaran
On October 29, the Federal Reserve announced that it had ended its asset purchase programme (Quantitative Easing or QE3). The communication issued by the Federal Reserve Open Market Committee suggested that the Federal Reserve was now more confident about the economic recovery in the United States and that it was looking ahead to make monetary policy more normal again with positive nominal interest rates. Based on this perception, many had begun to pen their stories of doom for emerging economies. It is true that, in the past, when the FOMC tightened US monetary policy by hiking interest rates, emerging economies had suffered. In 1994, it was Mexico. In 1997-98, it was Russia and Asian countries. In 1999-2001, Brazil and Argentina suffered. There was a financial market tumble in 2006 when the Federal Reserve talked tough but it did not raise interest rates after the tough talk. So, who is going to be hurt this time?
First, the assumption that the Federal Reserve is on course to restore normal monetary policy is far from assured. Barely two weeks ago, when stock markets appeared wobbly, out came Federal Reserve officials with soothing comments and even promises of reconsideration of termination of asset purchases. With stock markets having stabilised and reached newer highs, the Federal Reserve could afford to appear sanguine. In truth, it is hostage to the fortunes and fate of the stock market. The stock market has a veto over monetary policy in the United States. That is the objective reality.
Second, even though the Federal Reserve might have ended QE, it is not about to shrink its balance sheet any time soon. It is reinvesting maturing assets. So, liquidity is not being tightened. With interest rates at zero still, there is enough liquidity to support the market and emerging economies are not about to be starved of US dollar liquidity as in the previous episodes of monetary policy tightening.
Third, America is still running a big non-petroleum real trade deficit. In 2014, it is on course to reaching 3.5% of real GDP, just shy of the peak of around 3.8% seen in 2006 and in 2006. The persistently high trade deficit ensures US dollar supply in the world.
Fourth, even as the United States is ending its asset purchase programme, others are cranking up theirs. On 31 October, the Bank of Japan unexpectedly boosted its asset purchase programme. In the first week of November, the European Central Bank might do so. The Bank of England appears in no hurry to start hiking interest rates. In the meantime, the Riksbank in Sweden cut its interest rate down to zero too. The world is littered with countries that have erased the time value of money. The emerging world need not fear the withdrawal of liquidity globally.
In fact, it is somewhat disingenuous to point out the vulnerability of emerging economies when the developed world has seen its overall non-financial debt ratio climb since 2008. Further, question markets over the future of Europe have grown bigger. Japan remains an enigma. Even in the United States, economic strength is skin-deep. For all the rage over the shale oil and gas boom, there is no spillover of the beneficial effects on other sectors. Otherwise, America’s non-petroleum trade deficit will be declining, instead of rising.
Since the summer of 2013, when emerging market assets tumbled when the Federal Reserve first mooted the idea of reducing its asset purchases, many emerging nations have set their house in order. Only Turkey and South Africa have somewhat sizeable current account deficits. India and Indonesia have brought down theirs. More importantly, India and Indonesia have had important political change and both their governments are headed by popular and decisive leaders. Indonesia’s government is relatively new but it holds promise. India’s government, in office for five months, has taken some bold decisions quietly. Its strength lies in pushing through big changes without appearing to rock the boat. India remains an attractive investment destination for portfolio investors by default.
Russia has a current account surplus but it has a political problem with the United States and Europe over Ukraine. Brazil’s current account deficit is not high (3.5% of GDP) but it is sticky. If anything, the big emerging economy that is vulnerable to sustained and/or larger than expected monetary policy tightening in the United States is China, despite its current account surplus. Its domestic economy is belatedly facing the aftereffects of an unsustainable credit and property price boom. However, China might be ‘too big to fail’ for the United States, given its linkages with the Wall Street and its holding of US Treasury Bills, Notes and Bonds. Hence, the United States might be unwilling to rock the economic boat in China too much.
Therefore, in summary, the United States is nowhere near a genuine tightening of monetary policy. Its commitment to returning its monetary policy to normal remains suspect. Other central banks are still engaging in asset purchases and providing global financial markets with ample liquidity. Select emerging economies might be vulnerable but broad-brush pessimism is uncalled for.
If anything, the risk is that emerging economies continue to bask in the glory of further capital flows, elevated asset prices and a false sense of well-being that they experienced in 2006 and in 2007. Far from being worried about an imminent change in policy in the US and the withdrawal of capital, they should actually be concerned about more capital flooding their economies and markets, beyond their capacity to handle it, in the course of 2015. Domestic complacency rather than international policy is the bigger risk for emerging economies in 2015.
(Dr. V. Anantha Nageswaran is an independent consultant on global macro-economy and investment strategy for asset managers.)
Views expressed are personal views of the author and do not constitute any investment recommendation