Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Abundant flows of global capital in search of fresh yield are unstoppable but unabsorbable.
The imposition of new capital controls is often appropriate but, nearly as often, ineffectual.
The development of local-currency capital markets is promising but immature. Macroprudential measures are easy to recommend but hard to specify, hard to design, and hard to implement politically.
The open economy trilemma may be an overly restrictive viewpoint, or perhaps it isn’t restrictive enough and should be replaced by a dilemma (with independent monetary policy or free capital flows the only options, no matter what the exchange rate policy).
There are no simple, immediately available solutions to these problems — which is why it’s difficult to understand the impact of developed-country monetary policy on emerging economies.
With that mind, here we look at three related items we’ve come across in the past few days, and briefly discuss each.
1) Optimism for EM risk assets?
The team from Capital Economics notes that the September recovery in emerging-market equities mostly took place before the Fed’s decision not to taper, offering a three-part explanation:
First, investors now appear to be coming round to the view that the Fed will reverse its accommodative monetary stance only slowly. Note that the largest gains for EM equities were on the days following the disappointing payrolls release, which dampened expectations of tapering, and after the announcement that Larry Summers (perceived to be a more hawkish candidate) had dropped out of the nomination process to be the next Fed chair.
This suggests that markets started to price in more dovish Fed behaviour ahead of the Fed’s September decision. This has eased the fears seen in May and June when EM equity prices fell by 17% in dollar terms as investors moved out of EM equities in anticipation of the ending of the Fed’s QE3 programme. …
Second, the economic news from emerging markets has become more favourable, with strong Q2 GDP releases in both Brazil and China having a positive impact on sentiment. While the first half of the year saw growth in emerging economies decelerate, our GDP tracker suggests that activity in the emerging world has now stabilised. …
Finally, even after the recent rise in prices, EM equity market valuations generally remain favourable. The price/earnings ratio is around 15% below its historical average and valuations are attractive relative to developed market equities.
Indeed, the P/E ratio of EM equities is nearly five points less than that in developed markets. And while the dividend yield on EM equities has fallen from nearly 3% to 2.8% in recent months, it remains above its 10-year average of 2.5%.
Not yet time to get complacent, or to dismiss the possibility of a very bad outcome in an individual country (India remains a particular worry). But hopefully these are nascent signs that broader growth trends have stabilised for now.
2) Is the Fed’s continued QE hurting or helping emerging markets?
The howls of currency-warmongering rage each time the Fed embarked on a new asset purchase program were later replaced by whimpers of confusion ahead of the expected onset of tapering.
Are delays in tapering or ending QE merely postponing the unavoidable and thus setting the stage for a bigger catastrophe later? Or would further delays helpfully give emerging-market countries time to address their domestic problems while also boosting the US economy, which itself would have net positive effects on developing countries even if it keeps a few bubbles inflated or leaves carry trades unwound?
Sid Verma of Euromoney, riffing on an interview with Singapore finance minister Tharman Shanmugaratnam, has an excellent discussion of these arguments — and implicitly gets across the difficulty for emerging-market policymakers in deciding what they should prefer the Fed to do right now.
A couple of excerpts, first with Shanmugaratnam’s main point:
Shanmugaratnam said the EM-rout over the summer, and the financial imbalances built up in economies in Asia since 2009, highlighted how high-yielding EMs were unable to escape the risk of credit-driven current-account deficits, a corresponding dependence on fickle foreign capital, during a prolonged period of US monetary stimulus.
This, he said, has driven a flood of capital into emerging economies with modestly-sized financial systems. … He said the Fed had a self-interest in factoring in the negative feedback loop from its policies. “The world is becoming more interconnected and aggregate demand from emerging markets increasingly matters for the US,” he said.
If the emerging world goes through a significant retrenchment [in part, triggered by Fed-induced unsustainable credit stimulus], it will rebound on the US exports and global growth,” he added, without calling on the Fed to delay tapering. …
And the second, explaining why the US is unlikely to give the plight of emerging markets much weight:
A January 2013 research paper by the Federal Reserve Bank of New York concluded a 10-basis-point reduction in long-term US Treasury yields results in a 0.4-percentage-point increase in the foreign ownership share of EM debt, in turn reducing local government yields by 1.7%, across the board.
While Fed policies drive the global monetary cycle and shape EMs’ export-led growth prospects, a slowdown in developing nations has a more limited impact on the US real economy, even amid greater globalization, says Williams at Capital Economics, buttressing Bernanke and Yellen’s argument the Fed should follow its dual domestic employment-inflation mandate, rather than expand its remit to consider emerging economies.
According to Yardeni Research, given the typically consumption-driven nature of US growth, at 70% of GDP, the beta between US and EM GDP is low. …
According to the research shop, total exports of goods and services account for 14% of US GDP. Of this, US merchandise exports to emerging economies account for 67% of total exports, up from about 50% in 1990.
Although US corporate profitability, often tied to global growth, would suffer in the event of a prolonged EM downturn, cheaper US commodity imports could help partially offset this impact, say analysts.
The usual calls for structural reform and international coordination follow, but again it’s unclear which Fed decision — tapering or not tapering — is most helpful to emerging-market countries now. Sid’s whole article is recommended.
An alternative hypothesis is that our policies were indeed responsible for the very low level of long-term rates, but in part through a more indirect channel.
According to this view, real and nominal term premiums were low not just because we were buying long-term bonds, but because our policies induced an outward shift in the demand curve of other investors, which led them to do more buying on our behalf–because we both gave them an incentive to reach for yield, and at the same time provided a set of implicit assurances that tamped down volatility and made it feel safer to lever aggressively in pursuit of that extra yield.
In the spirit of my earlier comments, let’s call this the “Fed recruitment” view. I take the events of the past few months to be evidence in favor of the recruitment view. …
… an understanding of this channel highlights the uncertainties that inevitably accompany it. If the Fed’s control of long-term rates depends in substantial part on the induced buying and selling behavior of other investors, our grip on the steering wheel is not as tight as it otherwise might be.
Even if we make only small changes to the policy parameters that we control directly, long-term rates can be substantially more volatile. And if we push the recruits very hard–as we arguably have over the past year or so–it is probably more likely that we are going to see a change in their behavior and hence a sharp movement in rates at some point.
Thus, if it is a goal of policy to push term premiums far down into negative territory, one should be prepared to accept that this approach may bring with it an elevated conditional volatility of rates and spreads. …
… one scenario to be worried about may simply be a sharp increase in marketwide rates and spreads at an inopportune time, such that it becomes harder for us to achieve our dual-mandate objectives.
The recruitment channel could well explain the aggressive swings in emerging-market currencies and flows. Yet the speech also left me wondering why Stein didn’t pursue this line of thinking one iteration further.
Stein worries about a scenario in which rates unexpectedly move against the Fed at an “inopportune” time, and the central bank no longer will have the tools to counter the subsequent economic impact. (In this scenario it was overuse of its tools that contributed to the rate spike in the first place.)
That the Fed will lack the tools to achieve its dual-mandate objectives in this scenario is a reasonable worry, but Stein doesn’t address the problem of not doing more. For in pulling back too early, the Fed would already be falling short of its objectives and signaling an unwillingness to do what is necessary to achieve them, both now and into the future.
The risk, then, is that the Fed’s own future commitment to these objectives is called into question. Diminished expectations of the Fed’s willingness to act — and therefore diminished expectations of future growth — become entrenched. Economic agents and market participants act accordingly, and sluggish growth becomes the norm.
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On several occasions (see here, here, here, here, and here), Tyler Cowen has wondered about the extent to which US monetary policy should be more cosmopolitan, and consider its impact on emerging markets.
I don’t have a great answer, but I lean towards “some but not much”. Not because I’m callous, but rather because I think there are limits to what the US central bank should be expected to do. This is especially the case with the Fed’s impact on emerging markets, for which the “right” policy is unclear. And some of these countries will eventually have to deal with the instability that comes with a liberalised financial sector regardless.
So I doubt the Fed would be doing the world a favour by unilaterally adding a mandate to alter its policies according to their impact on global capital flows. The Fed is having enough trouble with the two mandates it already has.
A commitment to acting predictably when it is falling short on either of them at least allows other countries, and perhaps the relevant multilateral institutions, to prepare an appropriate response.
That’s not satisfying, and again much is unknown. But when problems have conflicting solutions, the least bad option is all that reasonably can be hoped for.
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