FYI | Feb 20 2014
By Greg Peel
The commencement of the tapering of bond purchases (QE) by the US Federal Reserve in January sparked an emerging market crisis. Tapering signalled the beginning of the end of “free money” and an eventual rise in US interest rates and as such prompted US investors to withdraw funds from high-yielding emerging market investments and bring the money back home.
The rush of capital outflows from emerging markets resulted in plunging stock markets and spiralling exchange rates with the US dollar, evoking fear around the globe and weakness on Wall Street. Emerging markets (EM) have provided the balance to developed market (DM) weakness since the GFC – weakness which has forced substantial money printing by DM central banks. 2013 appeared to be the year which marked a turnaround in DM fortunes, leading to relief that the GFC fallout may finally have passed. Fed tapering is representative of this belief, but for every action, it would seem, there is an equal and opposite reaction. With Fed tapering set to continue systematically to its conclusion, will the world be plunged back into financial crisis once more in 2014 as EM economies collapse?
No, says Commonwealth Bank’s Global Markets Research.
For starters, EM crises are a dime a dozen, notes CBA, occurring, as they have done, in some country or another every year since at least 1970. Governments default on or restructure their debt every year. Currencies and equity indices crash in some economies every year. There are banking crises in at least a handful of economies every year. The frequency of such crises emphasises to CBA the need to analyse specifically local conditions when predicting the risk of an economy falling into crisis.
The most recent crisis was more selective than widespread across EMs. Argentina, Brazil, Turkey, Russia and South Africa were the main victims. This is of little surprise, suggests CBA, given each of these economies was suffering from any or all of high inflation, low economic growth and a large current account deficit, prior to the Fed’s policy announcement.
Virtually all EM economies have at least some financial and external risks that may tip them into crisis at any time, CBA points out. Presently, Latin America and Asia remain at the lower end of the regional risk spectrum while Emerging Europe, the Middle East and Africa are at the higher end. The individual economies at greatest risk are Brazil, Turkey, South Africa, Morocco and Egypt.
There is little doubt the announcement of Fed tapering triggered a rush out of EMs and the resultant crisis in January but following some emergency measures those EMs have stabilised and DM stock markets have moved on. Analysis shows there is little historical evidence of EM crises specifically occurring the year a Fed tightening cycle commences and no evidence of government defaults or banking crises one year following. There is nevertheless some correlation between Fed tightening and EM currency and equity crashes one year following, suggesting to CBA a higher incidence of crises should be evident in 2016. CBA expects the next Fed tightening cycle (rising interest rates) to commence in 2015.
The market’s fear is that as QE is reduced, the “wall of money” which flowed out of DMs and into EMs supported by that QE must reverse. CBA notes EM investments by DM economies grew by US$0.8 trillion between end-2007 and end-2012. But it should be noted that the amount of money flowing into EMs during the boom years of 2002-2007 totalled US$1.8 trillion.
These figures only measure equity and bond investment, and not cross-border bank lending or foreign investor direct investment. Foreign capital inflows into the US have a heavy skew towards equity and debt securities whereas equivalent inflows into EMs represent only 32% of all inflows, with bank lending representing 21% and foreign direct investment 47%.
Does this mean the crisis could be even worse? Well not if you consider many EMs are actually “net exporters” of capital, mostly via the offshore investments of sovereign wealth funds and central banks investing foreign exchange reserves. Total funds invested by the US in EMs is less than total funds invested by EMs offshore. Then there are the public investors.
EM public investors increased their assets under management by US$3 trillion in 2007-12 and now have over US$11 trillion under management. CBA estimates the bulk of this is invested in DM equity and debt instruments. The US$3trn flowing out of EMs into DMs in the QE era rather dwarfs the US$0.8trn following the other way.
CBA admits there are variations among individual EMs as to the extent of DM investment but the point is there is plenty of EM capital sitting in DMs that could be liquidated were EM outflows threatening to spark genuine crises.
The conclusion is CBA expects 2014 to feature greater financial volatility than a more stable 2013 now Fed tapering has begun and expects that there will be some level of crisis among individual EMs, albeit there always is. The analysts do not expect there will be regional or global recession, large downward pressure on the Aussie dollar or extreme financial turbulence.
CBA will not, however, guarantee there could not be unexpected contagion.
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