Will Fed tight­en­ing choke emerg­ing mar­kets?

Financial Mirror (Cyprus) - - FRONT PAGE -

As the Fed­eral Re­serve moves closer to ini­ti­at­ing one of the most long-awaited and widely pre­dicted pe­ri­ods of ris­ing short-term in­ter­est rates in the United States, many are ask­ing how emerg­ing mar­kets will be af­fected. In­deed, the ques­tion has been asked at least since May 2013, when thenFed Chair­man Ben Ber­nanke fa­mously an­nounced that quan­ti­ta­tive eas­ing would be “ta­pered” later that year, caus­ing long-term US in­ter­est rates to rise and prompt­ing a re­ver­sal of cap­i­tal flows to emerg­ing mar­kets.

The fear, as IMF Man­ag­ing Direc­tor Christine La­garde has re­minded us, is of a re­peat of pre­vi­ous episodes, no­tably in 1982 and 1994, when the Fed’s pol­icy tight­en­ing helped pre­cip­i­tate fi­nan­cial crises in de­vel­op­ing coun­tries. If the Fed de­cides to raise in­ter­est rates this year, which emerg­ing mar­kets are most vul­ner­a­ble to a cap­i­tal-flow re­ver­sal?

There is no ques­tion that emerg­ing mar­kets are highly sen­si­tive to global mar­ket con­di­tions, in­clud­ing not only changes in short-term US in­ter­est rates, but also other fi­nan­cial risks, as mea­sured, for ex­am­ple, by the volatil­ity in­dex VIX. Cap­i­tal-flow bo­nan­zas, of­ten spurred by low US in­ter­est rates and calm global fi­nan­cial mar­kets, end abruptly when th­ese con­di­tions re­verse.

By the end of the cur­rency crises in East Asia and else­where in the late 1990s, emerg­ing-mar­ket gov­ern­ments had learned some im­por­tant lessons. Five re­forms were par­tic­u­larly ef­fec­tive: more flex­i­ble ex­change rates, larger for­eign­cur­rency hold­ings, less pro-cycli­cal fis­cal pol­icy, stronger cur­rent ac­counts, and less debt de­nom­i­nated in dol­lars or other for­eign cur­ren­cies.

Many, but not all, de­vel­op­ing and emerg­ing-mar­ket coun­tries took steps to im­ple­ment th­ese de­sir­able poli­cies. Their choice was put to the test dur­ing the 2008-2009 global fi­nan­cial cri­sis. Coun­tries that had adopted such re­forms were, on av­er­age, less ad­versely af­fected. Those that had not, par­tic­u­larly mid­dle-in­come coun­tries in Cen­tral Europe and the con­ti­nent’s pe­riph­ery, tended to be hit the hard­est.

In par­tic­u­lar, af­ter 2001, many de­vel­op­ing coun­tries over­came their his­toric pat­tern of us­ing pe­ri­ods of cap­i­tal in­flows to fi­nance large fis­cal and cur­rent-ac­count deficits. As a re­sult of re­duced debt and en­hanced re­serves, their cred­it­wor­thi­ness im­proved dur­ing the 2003-2007 boom. By 2008, they were in a strong enough po­si­tion to re­spond to the fi­nan­cial cri­sis by al­low­ing larger bud­get deficits and thus mit­i­gat­ing the down­turn in 2009. Chile was the star re­former, but other coun­tries – in­clud­ing Botswana, China, Costa Rica, Malaysia, the Philip­pines, and South Korea – also avoided pro-cycli­cal fis­cal poli­cies.

Un­for­tu­nately, pol­icy back­slid­ing is jeop­ar­diz­ing this his­toric “grad­u­a­tion” from pro-cycli­cal­ity. Coun­tries like Brazil did not take ad­van­tage of the re­cov­ery from 2010 to 2014 to strengthen their bud­gets, and are now in a dif­fi­cult po­si­tion. Some of th­ese coun­tries used the re­newed cap­i­tal in­flows to run large cur­rent-ac­count deficits af­ter 2010 as well. Such deficits, to­gether with high in­fla­tion rates, earned Brazil, Turkey, and South Africa their membership on the Frag­ile Five list of coun­tries that were hit par­tic­u­larly hard by Ber­nanke’s an­nounce­ment in 2013. In­dia and In­done­sia were on this list as well, though they have be­gun to move in the right di­rec­tion since then (thanks in part to new gov­ern­ments).

Then there are the coun­tries – in­clud­ing Venezuela, Ar­gentina, and Rus­sia – that never moved in the re­form di­rec­tion in the first place. They were tem­po­rar­ily bailed out by strong world prices for their ex­port com­modi­ties, but that ended last year.

A less vis­i­ble threat is the de­nom­i­na­tion of debt in dol­lars and other for­eign cur­ren­cies. The cur­rency crises of the 1980s and 1990s were par­tic­u­larly dev­as­tat­ing be­cause de­val­u­a­tions so of­ten hit coun­tries that had bor­rowed in dol­lars. This re­sulted in a “cur­rency mis­match” be­tween dollar li­a­bil­i­ties and rev­enues that were of­ten de­nom­i­nated in lo­cal cur­ren­cies. When the cost of dol­lars dou­bled in terms of pe­sos or ru­piah, oth­er­wise-sol­vent lo­cal banks and man­u­fac­tur­ers could no longer ser­vice their dollar debts. Ow­ing to this ad­verse bal­ance-sheet ef­fect, de­val­u­a­tion turned out to be con­trac­tionary, lead­ing to se­vere re­ces­sions.

Most emerg­ing-mar­ket bor­row­ers had learned their les­son by the turn of the cen­tury, as ex­change-rate volatil­ity had made the risks of cur­rency mis­match more tan­gi­ble. When in­ter­na­tional in­vestors came knock­ing again in 2003, many emerg­ing mar­kets de­clined to bor­row in dol­lars or other for­eign cur­ren­cies. In­stead, they took the in­flows in the form of di­rect in­vest­ment, eq­uity, or debt de­nom­i­nated in lo­cal cur­rency. The rel­a­tive ab­sence of mis­match was one of the rea­sons why emerg­ing mar­kets did much bet­ter when their cur­ren­cies de­pre­ci­ated in 2008-2009 than in past crises. Ex­cep­tions like Hun­gary, where home­own­ers had fool­ishly bor­rowed in seem­ingly cheap eu­ros and Swiss francs, proved the rule.

Un­for­tu­nately, in the last five years, many emerg­ing mar­kets have re­verted to bor­row­ing in for­eign cur­rency. Though, for the most part, gov­ern­ments have con­tin­ued the shift away from dollar debt, the cor­po­rate sec­tor, as the Bank for In­ter­na­tional Set­tle­ments has warned, has been tempted by ul­tra-low in­ter­est rates.

The Chi­nese pri­vate sec­tor may have the big­gest prob­lem. Much of its re­cent bor­row­ing vi­o­lates key tenets of hard­earned wis­dom gained in past crises: it is for­eign ex­change­de­nom­i­nated, short-term, shadow-bank-in­ter­me­di­ated, and hous­ing-backed.

Even though the Fed has not yet started rais­ing in­ter­est rates, the well-es­tab­lished US eco­nomic re­cov­ery and the prospect of mon­e­tary tight­en­ing have, over the last year, caused the dollar to ap­pre­ci­ate sharply against most cur­ren­cies, those of emerg­ing mar­kets and ad­vanced coun­tries alike. If the Fed tight­ens as early as the mid­dle of this year, fur­ther dollar ap­pre­ci­a­tion is likely. Those who have been play­ing with mis­matches may be about to get burned.

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