Fed’s attitude to emerging markets is much too cavalier

THE US Federal Reserve has told Asia, Latin America, Africa and Eastern Europe to drop dead. This has the makings of a grave policy error: a repeat of the dramatic events in 1998 at best; a full-blown debacle and a slide into a second leg of the Long Slump at worst.

Emerging markets are now big enough to drag down the global economy. As Indonesia, India, Ukraine, Brazil, Turkey, Venezuela, South Africa, Russia, Thailand and Kazakhstan try to shore up their currencies, the effect is ricocheting back into the advanced world in higher borrowing costs. Even China felt compelled to sell $20-billion of US Treasuries in July.

“They are running down reserves by selling US and European bonds, leading to a self-reinforcing feedback loop,” said Simon Derrick of investment manager BNY Mellon.

We are told that emerging markets are more resilient than in past crises because they have $9-trillion (about R93-trillion) of reserves.

But any use of that treasure to defend the exchange rate entails monetary tightening and therefore inflicts a contractionary shock on countries already in trouble.

We are also told that emerging markets borrow in their own currencies these days, immune to the dollar squeeze that caused such havoc in the early ’80s and mid-’90s.

This is true, but double-edged. India, Brazil and others will surely be tempted to stop fighting markets, let their currencies slide and inflict the pain on foreigners.

Mirza Baig from BNP Paribas advises them to embrace devaluation, calling it futile — and costly — to defend quasi-pegs.

Baig says foreigners bear 90% of the currency risk in Malaysia, 81% in Thailand, 79% in Korea and 74% in India. So let them take the haircut. But if they do so, they will inflict a deflationary trade shock on the West. The eurozone is in no fit state to handle that, nor is Britain.

We are in uncharted waters. Emerging markets were less than 15% of global GDP in the early ’80s, when tightening by the Fed brought Latin America crashing down. That was an ugly episode for Western banks, but easily contained. China was then an autarky, shut off from the world. The Soviet Union and its satellites formed a closed system.

The picture was already very different by the mid-’90s. By then emerging markets had grown to a third of global GDP, big enough to rock the boat, as Fed chair Alan Greenspan discovered after Russia’s default in August 1998. He became worried enough to canvass Fed governors that month on the need for a response. The Fed cut rates in September, October and November, but it was not enough to stop the crisis spinning out of control as currencies crashed across East Asia.

If the stakes were high then, they are higher now. Emerging markets are half the world economy, according to IMF data. The “power ratio” is no longer 1:2 but 1:1. Yet all we hear from the Fed are dismissive comments that the rout of emerging markets is not its problem.

“The big risk is that Fed tapering will spark a rush for US dollars,” said Lars Christensen from Danske Bank. “Central banks around the world think they have been doing something they shouldn’t do with all this stimulus, and they want to unwind it as quickly as possible. But the danger is that they will go too far and trigger a relapse like 1937.”

The Fed has a duty of care to emerging markets, because its own hands are hardly clean. Zero rates and quantitative easing were the cause of dollar liquidity flooding these countries. It was the main reason net capital flows into emerging markets doubled to $8-trillion after 2008. Globalisation has entrapped the Fed. Like it or not, the Fed is the world’s monetary superpower.

The exodus of money from emerging markets that we have seen so far is nothing compared with what could happen if this episode is mishandled. If the Fed thinks that the rest of the world will have to “adjust to us” as it insists on draining global liquidity, it may have a rude surprise yet again. — © The Daily Telegraph, London