Thursday, December 25, 2014

25/12/2014: Unwinding Western Excesses, Squeezing Emerging Markets


Just in case you need a scary story for the holidays seasons, here's one from economics. Some time ago, we've learned that zero bound (extremely low) interest rates in the advanced economies spell quite a disaster for the emerging markets, where the economies are now suffering from triple pressures: declining commodities prices (on which many emerging markets economies often rely for exports, declining demand for their exports of goods, and declining investment inflows from the advanced economies.

But that's just the beginning. It seems that any unwinding of the QE deployed in the West is likely to hammer the emerging markets more.

Here's a World Bank paper from earlier this year on the topic: Burns, Andrew and Kida, Mizuho and Lim, Jamus Jerome and Mohapatra, Sanket and Stocker, Marc, Unconventional Monetary Policy Normalization in High-Income Countries: Implications for Emerging Market Capital Flows and Crisis Risks (April 1, 2014). World Bank Policy Research Working Paper No. 6830: http://ssrn.com/abstract=2419786

What the authors found is that as "the recovery in high-income countries firms amid a gradual withdrawal of extraordinary monetary stimulus, developing countries can expect stronger demand for their exports as global trade regains momentum, but also rising interest rates and potentially weaker capital inflows. …In the most likely scenario, a relatively orderly process of normalization would imply a slowdown in capital inflows amounting to 0.6 percent of developing-country GDP between 2013 and 2016, driven in particular by weaker portfolio investments. However, …abrupt changes in market expectations, resulting in global bond yields increasing by 100 to 200 basis points within a couple of quarters, could lead to a sharp reduction in capital inflows to developing countries by between 50 and 80 percent for several months."

Wait, we are witnessing this already, in part, as bond prices in a number of emerging economies are following oil prices down. And worse, if the above applies to corporate yields, the same will apply to government yields. Thus, 'normalisation' in the West can yield double shock to debt markets in the emerging economies.

World Bank paper has more on the subject: "Evidence from past banking crises suggests that countries having seen a substantial expansion of domestic credit over the past five years, deteriorating current account balances, high levels of foreign and short-term debt, and over-valued exchange rates could be more at risk in current circumstances. Countries with adequate policy buffers and investor confidence may be able to rely on market mechanisms and countercyclical macroeconomic and prudential policies to deal with a retrenchment of foreign capital. In other cases, where the scope for maneuver is more limited, countries may be forced to tighten fiscal and monetary policy to reduce financing needs and attract additional inflows."

So the best case scenario, sovereign wealth reserves (if any) will be exhausted on 'normalising' the US, UK, Euro Area and Japan, while if none are present, tough luck - the emerging economies are into a tailspin. They'll have to relieve the path of austerity-driven internal devaluations. Just because the West has ramped printing presses up so much, any 'normalisation' is going to be a disaster. If that is not a case of beggar thy poorer neighbour by enriching thy stock markets strategy, then do tell me what is?

And in another paper, "Tinker, Taper, QE, Bye? The Effect of Quantitative Easing on Financial Flows to Developing Countries" the same authors looked at gross financial inflows to developing countries over 2000-2013 (see: World Bank Policy Research Working Paper No. 6820: http://ssrn.com/abstract=2417518).

As above, authors found evidence "for potential transmission of quantitative easing along observable liquidity, portfolio balancing, and confidence channels. Moreover, quantitative easing had an additional effect over and above these observable channels, which the paper argues cannot be attributed to either market expectations or changes in the structural relationships between inflows and observable fundamentals. The baseline estimates place the lower bound of the effect of quantitative easing at around 5 percent of gross inflows (for the average developing economy), which suggests that of the 62 percent increase in inflows during 2009-13 related to changing global monetary conditions, at least 13 percent of this was attributable to quantitative easing. The paper also finds evidence of heterogeneity among different types of flows; portfolio (especially bond) flows tend to be more sensitive than foreign direct investment to our measured effects from quantitative easing."

So broadly-speaking, QE is impacting bond/debt flows and unwinding QE can be a costly proposition for the emerging markets.


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