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Sunday, October 6, 2013
Emerging Markets and the Unwinding of Quantitative Easing
Emerging Markets
and the Unwinding of Quantitative Easing
Otaviano Canuto
Capital Finance International, Autumn 2013 (Forthcoming)
The mid-year
season was marked by a strong pressure of capital outflows and exchange rate
devaluations in several systemically relevant emerging market economies.
Announcements in May that the Federal Reserve had started to focus on phasing
out its asset-purchase program – otherwise known as quantitative easing or QE)
sparked a surge in bond yields that triggered an asset sell-off in those
emerging markets. Although subsiding in September, particularly after the Fed
announced that “tapering” would not begin yet, concerns remain about what will
happen when the actual unwinding of QE eventually unfolds. We argue here that
events since May could ideally provide a “fire drill” that might induce
emerging markets to address various policy shortcomings that have been exacerbated
by the flood of global liquidity in the last few years.
Quantitative
easing has been countercyclical in advanced economies…
After lowering policy
interest rates to near zero, central banks in the major economies started in
2009 an expansion of their balance sheets. The steady purchase of government bonds and
other assets by G4 central banks have taken their asset holdings to currently around
15% of global GDP, from roughly 8% in 2008 (Chart
1).
Chart 1
The initial
rounds of central bank asset purchases aimed at avoiding a deepening of on-going
asset liquidation processes caused by private agents trying to deleverage en
masse after the Post-Lehman financial quasi-collapse or, in the case of the euro
area, when the crisis of confidence on the euro convertibility unfolded.
Without such backstop, more intense asset deflation processes could have been
accompanied by widespread bankruptcies and further aftershock GDP losses (Brahmbhatt
et al, 2010).
In the case of
the US Fed, subsequent rounds of asset purchases, besides propping up mortgages
through acquisition of mortgage-backed securities (MBS), aimed at lowering
long-term yields. This can be seen in the evolution of the ten-year US Treasury
term premium –accounting for real and inflation risk premiums - toward negative
levels also depicted in Chart 1.
Even during its
more aggressive stage, the Fed’s QE is perhaps best seen as an accommodative,
counter-cyclical policy. Chart 2
shows how the money multiplier practically “fell off a cliff” on both US and
European sides of the Atlantic after the crisis struck, reflecting private
agents’ preference for holding very high levels of excess reserves of liquidity
rather than creating broad money through credit expansion.
Chart 2
Unconventional
monetary policies - QE combined with “forward guidance”, i.e. signaling of
central banks’ future policies - prevented the unraveling of the financial
system and of private asset-liability structures, and countervailed an aggregate
demand slump in affected countries. Such policies have thus helped smooth the
private sector deleveraging process and, in the case of the Euro, helped save
the currency by reducing perceived risks of convertibility. The countercyclical
effect could arguably have been stronger if accompanied by countercyclical
fiscal policies in the US. On the euro area side, the ECB action would also
arguably have been more effective if followed by less austerity and/or structural
reforms in crisis-ridden countries, faster euro-wide institutional development and
a more proactive writing-off of impaired assets (given the costs of
“procrastination” - Canuto, 2013a). Notwithstanding
such concerns, with the benefit of hindsight one can still assert that such
unconventional monetary policies helped avert a graver macroeconomic disaster.
On the other
hand, one may point out several factors tending to decrease the effectiveness and
increase the risks of QE policies going forward (Caruana, 2013). Prolonging the
period with central bank support to risk taking not only creates hazards by
itself, but also raises the temptation to “evergreen” impaired liabilities with
the hope of postponing – perhaps forever - the acknowledgment of losses.
Furthermore, future normalization of central bank balance sheets becomes even
more challenging. It is no surprise then that, last May, rising confidence on
the durability of the US economic recovery yielded growing Fed references to a
“tapering” – shrinkage at the margin of asset purchases – probably later in the
year.
… And procyclical for
emerging market economies
At the outset of
the period of unconventional monetary policies in advanced economies, one could
anticipate a massive capital reallocation and associated changes in leverage
capacity moving from advanced to emerging market economies. Gloomy prospects
for advanced economies and the euro area crisis, combined with diverse channels
of transmission for QE, would probably pave the way for portfolio shifts to
emerging markets, helped by their post-2008 resilience. Indeed, prices of
emerging market assets (including financial assets and real estate) were
already reflecting such a relative change of fundamentals between the two
groups of economies and some analysts pointed out a major potential of risks
for emerging markets in case excessive euphoria prevailed and finance-led asset
bubbles were allowed to rise (Canuto, 2011).
In retrospect, it
is evident that the world experienced a significant increase in assets and
exposure to emerging markets in 2009-12, despite efforts by these economies to
introduce capital controls and macroprudential measures (Canuto and
Cavallari, 2013).
Outstanding emerging corporate bonds grew fast throughout the period. “Dedicated”
emerging market equity and bond funds were bloated and followed by the much
larger “crossover segment” (retail, hedge funds, and institutional). To
different country-specific extents, this wave of global liquidity helped fuel
credit booms, asset price inflation and macroeconomic over-heating in emerging
market economies (Caruana, 2013).
In the case of
equities, as illustrated in Chart 3,
the tide started to turn last year when news on a growth slowdown in major
emerging markets predominated (on China and Brazil, see Canuto, 2013b). But it was only
last May that significant global portfolio rebalancing was put in motion, when upbeat
news on US employment released on May 3th firmed the positive outlook for its
economy, followed by an uptick on long-term yields and on May 22th a Fed talk about
shrinking – and eventually reversing – its asset purchase program made public –
see Charts 3 and 4. While unconventional monetary policies have been countercyclical in advanced economies implementing
them, they have had pro-cyclical
consequences on emerging markets -- 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.
The global portfolio adjustment has seen a movement away
from countries/markets deemed as vulnerable to QE unwinding and toward those
whose prospects appear likely to improve as a consequence of possible future
policy change. Chart 5 shows how,
prior to the September calm down, exit flows and exchange-rate devaluations were
not distributed evenly among emerging market economies, but rather concentrated
on large countries exhibiting current-account deficits (Brazil, India, South
Africa, Indonesia, and Turkey). However, even China felt ripple effects through
a severe liquidity squeeze in its interbank market in June, partially
reflecting an accentuated slowdown in US dollar inflows in late May [see BIS (2013) on this and domestic
factors behind the brief but acute episode
of interbank volatility in China.]
Chart 3
Chart 4
Chart 5
The recent
emerging market sell-off may have turned out to be a timely wake-up call for
the post-QE world
The effects of an announced "tapering"
-- reduction at the margin -- of monthly asset purchases in the near future by
the Fed was felt immediately, even
though its date start was yet to be established. A frequent question now asked
is whether U.S. long-term Treasury yields will skyrocket when the Fed actually begins
to shrink its balance sheet toward more "normal" levels, and if they
do, could the resulting upheaval make the recent emerging market turmoil look
like a walk in the park.
Two factors may mitigate the
scenario of skyrocketing long-term interest rates. First, if we are right in
our description above, the Fed's balance sheet expansion has not been much
greater than the world's demand for liquidity in dollars. There is ground to
believe that the Fed mostly accommodated the private (bank and non-bank) demand
for "excess reserves", nudging down the nominal term premium later in
the process. Provided that the US economic recovery settles in and the private
demand for long-term bonds – and other assets, like MBS -- normalizes, the Fed
will not have to dump unwanted assets on the market and, thus, be obliged to 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 and the decision
not to start tapering in September yet confirms its propensity to move
cautiously and gradually.
This leads us to the second reason
for not expecting interest rates to go to the roof. 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.
Most emerging markets are currently not as vulnerable as they were in previous episodes
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 emerging market currencies sitting-ducks for
speculative attacks. Furthermore, reserve cushions are much larger, both
corporate and public-sector debt positions 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. The recent credit
boom in some countries has left a vulnerable legacy, especially in Asia - Chart 6 – but likely a more manageable
one, at least as compared to previous experiences. The debt legacy from China’s
credit-based real estate boom in the last few years can ultimately be addressed
with substantial official reserves and the available fiscal space.
Not by chance, the policy space
available in emerging market economies most affected by the recent sell-off has
already been put into action to avoid the emergence of vicious circles that spirals
of capital outflows and exchange rate depreciations might have caused. Such
policy reactions have been as important to the September calm as the signs of
caution in the QE taper coming from the Fed.
Chart 6
Provided that we are right regarding
caution and gradualism in the exit from central banks’ massive asset purchase
programs, as well as on the scope for emerging market policy reaction, the
global portfolio adjustment launched in May can be seen as offering an orderly
fire-drill for the real unwinding of QE. At the very least, those emerging
market countries most likely to be affected have greater recognition of their
vulnerability from splurging in the global liquidity pool and leaving their
fiscal and/or current-account deficits unaddressed.
Regardless of the role played by the
liquidity wave flooding into emerging market economies, these countries have in
general been too complacent over the need for structural reforms in order to
explore new growth opportunities (Canuto, 2011). We noted above how procrastination in adjusting and
restructuring portfolios is a potential downside of QE. To some extent, the
aggravation of fiscal and balance-of-payments fragilities in some
liquidity-receiving emerging markets, facilitated as an unintended consequence
of QE, has exactly been an example of such an accommodation. From this
perspective, unwinding QE policies may ultimately be good news for emerging
markets, especially if the withdrawal of global liquidity is followed by a
sharper focus on promoting country-specific reform and restructuring.
References
Brahmbhatt, M.,
Canuto, O. and Ghosh, S. 2010. Currency wars
yesterday and today,
Economic Premise n.43, December.
Canuto, O.
2013b. China, Brazil -
two tales of a growth slowdown, Capital Finance International, Summer.
Canuto, O. and
Cavallari, M. 2013. Monetary policy
and macroprudential regulation - whither emerging markets, World Bank
Policy Research Papers, n.6310, January.
Caruana, J.
2013. Debt, global
liquidity and the challenges of exit, 8th FLAR-CAF International
Conference, Cartagena, Colmia, July 8.
Saturday, June 25, 2011
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