The emerging-market squeeze

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THE flow of troubling news out of emerging markets is picking up. Equity indices around Asia continued their recent losing streak this morning. Though India has borne the brunt of recent market punishment—the rupee’s epic slide has continued this week—there is plenty of pain to go around. Indonesian stocks have tumbled more than 10% over the past few days. Growth is cratering around the region.

Most news stories relate the carnage to anticipated changes in Federal Reserve policy: tapering, which may begin in September or October, of the pace of stimulative asset purchases. But why should that matter?

Large-scale asset purchases, or quantitative easing (QE), are generally described as working through several channels. One is an expectations channel. Purchases may help communicate central bank goals or increase policy credibility. Purchases can have a fiscal effect; by lowering expected government borrowing costs QE may reduce expectations of future taxation, encouraging more work and investment in the present.

Empirical assessments focus overwhelmingly on a third channel: portfolio rebalancing. When a central bank buys certain kinds of assets they leave the banks or funds who sold them the assets short of the particular kind of asset the central bank bought. So a fund that intends to keep a certain share of its portfolio in safe-ish long-term debt will sell Treasuries to the Fed in exchange for newly printed cash, but will then find itself in need of portfolio rebalancing to get back to its preferred distribution of risk, maturity, and so on. The fund then takes its cash and buys something similar to the assets it sold: highly rated mortgage-backed securities or corporates, for instance, or the safe debt of foreign governments. But the funds selling those assets will also need to rebalance, and they may adjust their portfolios by purchasing safer emerging-market debt or equities. As the money works its way through the system it raises asset prices around the economy. And because some of the rebalancing involves purchases of foreign assets, they weaken the domestic currency and can reduce borrowing costs and raise equity prices abroad.

As rich-world central banks amped up their QE programmes, many emerging markets voiced their frustration. Lower rates and higher equity prices might have been a useful thing for slumping advanced economies, but booming emerging economies risked being pushed beyond their growth capacity. Inflation rose across some emerging markets while concerns about financial bubbles grew. Yet this process probably generated net benefits. Here’s economist Menzie Chinn, in a recent paper on the international spillover effects of QE:

The international dimension of the anxieties is centered, I believe, on the fact that advanced economy measures force a choice upon emerging markets: to accept capital inflows (perhaps offsetting domestic effects by sterilisation), to stem those inflows by way of capital controls, by allowing currency appreciation, or a combination of these measures. The (understandable) fear is that such capital inflows will spark a credit boom-bust cycle. The choices are most stark for small open economies.

However, the benefits of expansionary monetary policy outweighs the costs. If the advanced economies undertake expansionary policies that tend to weaken their respective currencies, then one is tempted to say that this is a wash, with no advantage conferred to a given country. Yet, if the unconventional measures raise the inflation rate, thereby reducing real interest rates, and spur domestic economic activity, both the advanced economies and the emerging market economies benefit.

But one of the ways these policies manifested themselves was in growth in emerging-market current-account deficits [update: I should be clear in noting that only some emerging economies have been running deficits; China, of course, is a notable exception ]. Cheap financing allowed emerging economies to temporarily live beyond their means, borrowing the difference from abroad: capital flows into such countries enabled them to import more than they exported.

Now fast-forward a couple of years. Financial markets had been moving money around based on expectations that central banks would end up buying a very large chunk of assets. But beginning in the spring Federal Reserve officials made statements hinting that they would in fact end up buying a somewhat smaller chunk of assets. As financial markets began to react to the change in outlook, the previous stimulative effects of QE started to unwind. As funds realised they would not need to replace as many Treasuries as they thought, Treasury prices fell (and yields rose) and so did prices for Treasury substitutes. That knock-on effect made its way around the world. Prices of emerging-market assets also sank, as did emerging-market currencies.

This is creating headaches for some of those emerging economies, and especially those that had been running big current-account gaps. Borrowing costs are rising; firms and households needing to roll over short-term debt will have to do so on less advantageous terms than they received a year or two ago. (Any firms unwise enough to have borrowed in a foreign currency will be in big trouble.) Import prices will rise. Exporters could benefit, though important inputs (fuel especially) could grow damagingly expensive. There is some cause to worry that an orderly exit becomes a rush and then a panic, as knock-on effects from depreciation spark a broader loss in confidence.

The bigger concern, however, may be the threat of big policy errors in response to these dynamics. Recklessly imposed capital controls could fuel panic and impair long-run growth. Worse still, central banks may strangle their economies with high rates in an attempt to protect their currencies’ values. The end of QE risks squeezing demand around the world.

Recall the initial logic behind asset purchases: to boost demand in slumping rich economies. Higher demand was to some extent destined to be captured from abroad, through adjustments in currencies and the flow of money abroad. But the dominant effect, as Mr Chinn notes, was domestic reinflation. It was QE’s encouragement of domestic lending and borrowing that made it better than a strictly zero-sum game. Everyone is better off in a world with adequate demand.

Now, however, tapering plans are triggering effective monetary tightening despite the fact that advanced economies remain short of demand (most of them anyway; America certainly). In addition to easing off on the job of domestic reinflation, tapering is effectively communicating to the world, via markets, the message that America is prepared to shift more of its demand abroad. Weakening emerging-market currencies and a squeeze on current-account deficits are the flip side of that message: the price signal that leads emerging markets to sell more to Americans and buy less from them.

Yet emerging economies may end up fighting this transition. due to worries about the knock-on effects of sinking currencies, by raising interest rates (or failing to reduce them when a weakening economic situation might otherwise call for rate cuts). And that could produce a much broader demand shortfall across the emerging world.

To simplify things: QE was pro-cyclical for emerging markets but counter-cyclical for advanced economies and was probably beneficial on net. Now the end of QE may prove pro-cyclical in emerging markets (exacerbating ongoing slowdowns) but is also pro-cyclical or at best neutral in advanced economies (since tightening is occurring amid a continued demand shortfall). And so the end of QE may well be quite negative on net.

It would be extremely premature to warn of disaster. Rich-world central banks may react to market stumbles by pushing back the start of tapering, and emerging economies may avoid overzealous rate increases in the face of sinking currencies. But the world has reached a risky moment. Though advanced economies are a long way from full recovery and emerging economies are slowing, central banks are almost uniformly moving toward a tightening bias. If policymakers aren’t careful, things could end badly.

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