By Vinit Intoliya
Edited by Shulin VK Satoskar
The end of Quantitative Easing (QE) policy and tightening of monetary policy (ending the zero rate policy) by US Federal Reserves has added fuel to the grow- ing fear in emerging economies’ debt and equity capital markets. During the period 2009 to 2013, the emerging economies received large foreign investments, Fed alleviated the losses caused by the subprime crisis. Now the tables have turned and die is being rolled by US Fed as its economy has almost recovered. The fall of Chinese stock market has also forced Chairperson of Federal Reserves to hike interest rates. The brunt of this huge pile-up of trillions of dollar as debt will decrease the local currency value of emerging countries, which will further make servicing of these debts costlier and create volatility.
Dollar Carry Trade
Let us rewind the story a few years back when the financial crisis of 2007 struck with the burst of Housing bubble. The resulting crisis led to sharp cutbacks in consumer spending. The dual combination of financial market chaos and decrease in consumption led to collapse in business environment leading to contagion effect around the globe. US Federal Reserve resorted to various steps to boost the economy which includes the unconventional path called Quantitative Easing (QE). Three rounds of QE has raised the Federal Reserve’s balance sheet from around less than $1 trillion in 2007 to more than $4 trillion now. Along with QE, Federal Reserve used the most common approach to revive the economy by using zero interest rate policy (ZIRP). Both the steps were taken to increase investment and pump up more money into the economy.
From 2010 onwards, the yields had fallen drastically and investors were forced to search for higher yield financial instruments around the globe. The reason be- ing ZIRP and changes in bond buying behavior of Federal Reserve. At this time, many countries around the world have been impacted but emerging markets re- main financially intact i.e. overall financial position is good and are offering higher yields. This has created a situation of dollar carry trade i.e. a company in emerging economies issues US dollar denominated bonds which provides higher yield compared to US bonds. Hence, investors borrow money at zero interest rate and invest in emerging markets thus gaining higher yields. In turn, corporates of emerg- ing markets invest the proceeds from the sale of bonds into higher yielding instruments.
This whole scenario of global carry trade has been initiated due to large interest rate difference between emerging economies and U.S. This also led to the spiral of money supply growth which fueled economies and thus increased the demand for emerging markets bonds.
Why did Fed decide to increase interest rate?
From last year onwards, taper tantrum decision of Fed gives investors a hint that the honeymoon period of borrowing money at zero interest rate will be over soon. There were various reasons due to which Fed thinks that current US economy is in sweet spot to raise the interest rates.
– Controlling Mortgage and Unemployment rate
One of the intentions of US central bank behind the availability of easy money in the US economy was to bring the mortgage rate under control and once again individuals start investing fixed assets. From year 2008 to 2015, Fed was able to bring down the mortgage rate by around 200 percentage point. Currently, the US mortgage rate is hovering around 3.90%.
During the global crisis the unemployment rate jumped from 5% in December 2007 to 9% in June 2009 (as per National Bureau of Economic Research). The recession killed around 7.9 million jobs spreading bad sentiments across the na- tion. But now according to US labor department, the current unemployment rate has again reached 5% and private sectors has made highest hiring record. The Fed strongly believes that this improvement in employment rate will bring desired inflation and wages.
As consumer spending and wages have improved, the main agenda of Fed is to maintain the inflation which is persisting in the economy. In FY’15, in the first 6 months the country was experiencing negative inflation and in April’15, it touched -0.20% and currently in Aug’15 inflation is +0.20%. The Fed wants to maintain this inflation rate in the economy and to increase the cost of borrowings which will keep the economy on an even keel.
Fed Effect on Emerging Economies
With interest rate tweaks in any economy, there is higher probability of huge capital inflow and outflow from the economy. Whenever central bank increases the interest rate, it directly affects the currency of those countries. And when US hiked the interest rate, dollar will be strong and there will be a huge impact as it is rightly said by IMF Chief Christine Lagarde that it will create “spillover effect” and spread volatility in the financial markets. Impact on emerging economies can be seen in terms of reversal of capital flows and high US dollar denominated debt. These both factors are inter- dependent on each other.
As there is huge money outflow from the economy, it basically means For- eign Institutional Investors (FIIs) are taking out their money which they have invested in stock markets of the countries. It will create negative sentiments and there will be net sellers’ environment. Hence there will be dollar outflow from the economy and countries own currency will become weaker in terms of dollar. This directly impacts the trade of the country. From the below figure, it is clear that in last six months that the export and import of emerging economies are suffering a lot.
The huge impact has been largely faced by India and China. Six months before, export and current export has changed drastically. If at this time Fed in- creases the interest rate, there is higher chance of creating environment of “Twin Deficit” i.e. current account deficit and fiscal deficit of each country will increase and worsen the economy. The dwindling capital inflows will make countries in EM worse to pay their debts, spend on infrastructure and hence less corporate expansion.
The latest report by IMF says that the borrowings of emerging economy countries have been doubled in the last 5 years and reached to US$ 4.5 trillion. The foreign companies’ US dollar debt were increased from $6 trillion to $9 trillion. Since 2008, according to funds tracker EPFR, there is total outflow of US $9.3 bn during the 2nd week of June from emerging markets. In the past 7 years, emerging markets have seen biggest weekly outflows. Hence, own currency de- valuation and concurrent back flow of capital will make debt repayment difficult for emerging countries. Therefore, the strong dollar will create a ripple effect.
Is it really a matter of concern?
The continuous capital outflow has posed danger to the whole economy or this brunt will be faced by just equity traded funds market. It depends on each country on how to manage their monetary and fiscal policies and how it remains financially intact from external shock. In Feb’15, the Fed issued a list of countries calling “Fragile Five” which can be highly vulnerable to increase in interest rates. The list depends on each country’s external financial exposure. Brazil, Mexico and Turkey are in most threatening situations
It is believed that all countries that lie in EM category will not suffer badly. It rather depends on how fundamentally strong are the policies of each country. It can be seen that this whole outflow of money is not due to the fear that Fed is increasing interest rate but it is due to China stock market bubble crash and bad policies system which governs the economy.
For example, Brazil was once praised for its robust growth but now it is facing huge criticism due to massive public debt, corruption and continuous interest rate tapering leading to high inflation. This led S&P to downgrade the bond to junk category. Due to this, investors are thinking about parking funds elsewhere.
This behavior of ‘beggar thy neighbor’ policy creates upheaval at the macro level. At the same time, India is looking fundamentally very strong from a long term perspective. Currently, the reaction in Indian stock market is due to herd mentality. Basically it means that when there is panic at a global level, it will lead to high selloff. Equity market is more of a sentiment driven market. At this juncture, the main indicator which will quantify the strong position of economy will be debt to GDP ratio and other Foreign Exchange Reserves. Currently, all the countries in EM have decent amount of foreign reserves which makes them shock proof and able to survive for short run. But in the long run, central bank and government of each country need to work together and make policies financially viable rather than managing according to the impact of hiked rate in US.
Current exodus of capital is more due to fundamental changes in an economy and not because of fear of increasing rates. The end to bond buying program of Fed reserves from 2013 has send clear indication that Fed will increase the rates in future but once it will be done the after effects will be transitory. The emerging economies are facing structural breakdown and this slowness is directly or indirectly related to China. The latest stock market crash of China and US Fed thinks of hiking interest rate are coinciding. On this hypothesis, we cannot create causation effect as this turbulence is due to the fear of interest rate hike. If in future also the US Fed is increasing interest rate, the most vulnerable countries would be the one that depends a lot on external financings and also who have low foreign reserves.
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