By Chris Berry
- Despite the Fed continuing to taper the pace of asset purchases, it appears that Emerging Markets (EMs) have rebounded from their initial sell off.
- Has the crisis “vanished” as Bloomberg recently claimed or is this a lull in a secular downtrend?
- There are a number of indicators we can look at, but none are more telling than the direction of currencies and interest rates – higher rates will hurt growth prospects.
- Regardless of the “crisis talk”, EMs will continue to lead global growth, albeit at a slower pace than many would like.
- Does this, coupled with slow and presumably steady growth in the West augur for higher interest rates going forward? This is anathema to Central Bankers.
Are We Out of the Woods Yet?
In May of 2013 when then-Chairman Ben Bernanke announced his intention to eventually start tapering asset purchases in the United States, Emerging Market equities and currencies were the first, unwitting victims.
The thinking goes as follows:
As the Fed executes its asset purchase program, this adds liquidity to a global financial system already awash in it. This liquidity needs to find a home and various EMs, with sunnier near-term and long-term growth prospects, would be a perfect destination. Why invest in Western economies with interest rates so low? This influx of liquidity disguised underlying problems with current and capital accounts around the world.
However, when the Fed slows the pace of quantitative easing, this can alter the demand for EM financial instruments like equities or debt. With less liquidity headed to EM shores, central bankers and policymakers in these countries must continue to attract inflows to ensure growth. This is typically achieved by raising interest rates and offering a higher rate of return relative to other parts of the world.
Here is the problem:
Higher interest rates can act as a drag on economic growth, harming living standards. In addition, higher rates can lead to a stronger currency which can harm economies that are dependent on exports for growth.
A 6 month chart of the iShares MSCI Emerging Markets Index shows how EM equities got hurt as tapering continued and the resultant upturn when EM central bankers and policymakers got involved in the markets typically by raising interest rates to attract investment.
Source: Bloomberg
We can also see how EMs and Frontier Markets have performed relative to each other since the perceived end of the financial crisis. It’s interesting to see how the performance of these indices has converged in recent years. This supports one of our overall theses.
Source: The Economist
Cause and Effect
Central Bank officials have a set of tools they can employ to enforce their mandate of moderate inflation, price stability, and economic growth. These include asset purchases, interest rate manipulation, and open market operations. It is important to remember, however, that every action has a reaction. This cause and effect paradigm can be amplified by a number of issues including demographics and geopolitical realities. As various EM central bankers have used interest rates as a lever to slow capital outflows, this has finally helped halt the currency weakening unleashed by former Chairman Bernanke with his “taper talk”. The list below is by no means complete, but is indicative of how a sovereign country can protect its economy in a tightly integrated global financial system.
The Indian Rupee was hurt more than most by both the threat and execution of tapering until Indian Central Bank officials stepped in to halt the slide:
Source: Bloomberg
The Brazilian Real continues to struggle with tepid growth. Perhaps the BRIC acronym is no longer valid?
Source: Bloomberg
The Turkish Lira was in free fall until recently. Internal political instability complicated matters, but interest rates skyrocketed and brought the Lira under control:
Source: Bloomberg
The Thai Bhat has also suffered based on similar internal political instability:
Source: Bloomberg
The performance of the Russian Ruble really needs no explanation other than I think it shows you what happens when a country that is a demographic time bomb is overcome with expansionist impulses:
Source: Bloomberg
In each case, officials in these countries were forced to act. Currency depreciation, while helping exports, makes domestic goods like food, more expensive. As many citizens in the EMs spend a greater percentage of their disposable income on food relative to the developed world, this is a non-starter for any EM politician.
Turkey, South Africa, and Russia (to name a few) have all raised interest rates leading to the currency appreciation we witnessed above. This also puts forth the opportunity to enter into a carry trade where you sell a currency with a low yield (the USD, for instance) and use the proceeds to purchase a currency with a higher yield (any of the above). You pocket the yield spread. This doesn’t help “the man on the street” but is a consequence of interest rate differentials across the globe.
The Takeaway
Depending upon your perspective, a stronger currency isn’t a bad thing. A strengthening currency is indicative of confidence in the assets and investment opportunities in a specific country. Bloomberg recently reported that ETFs focused on emerging markets attracted $1.4 billion in inflows in the first three days of April alone. It would appear that when we wrote about “The Nonstory Surrounding the Death of Emerging Markets”, we were correct.
The real challenge for the global economy at this point is for specific countries to walk the fine line between tightening monetary policy and ensuring stable and steady growth. EMs must continue the structural reforms necessary to compete and thrive in a tightly integrated global economy while the developed world struggles to get back on its feet.
Robert Kahn, a Senior Fellow at the Council on Foreign Relations put it this way:
“If you look at the long arc of past emerging market crises, a lot of them were triggered by a tightening of global monetary conditions.”
This balancing act, amplified by mounting tail risks, is what central banking officials and policy makers are now faced with.
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