The response of the exchange rates of emerging markets and their equity markets to the Federal Reserve’s “taper,” i.e., reduction in asset purchases, continues to draw comment (see, for example, here). Most analysts agree that these economies are in better shape to deal with capital outflows than they were in the past, and that the risk of another Asian-type crisis is relatively low. But that does not mean that their economies will react the way we expect.
Gavyn Davies of Fulcrum Asset Management, who has a blog at the Financial Times, has posted the transcript of a “debate” he organized with Maurice Obstfeld of UC-Berkeley, Alan M. Taylor of UC-Davis and Dominic Wilson, chief economist and co-head of Global Economics Research at Goldman Sachs, on the financial turbulence in the emerging markets. “Debate” is not the best word to describe the discussion, as there are many areas of agreement among the participants. Obstfeld points out that there are far fewer fixed exchange rate regimes in today’s emerging markets, and many of their monetary policymakers have adopted policy regimes of inflation targeting. Moreover, the accumulation of foreign exchange by the central banks leaves them in a much stronger position than they were in the 1990s. Taylor adds fiscal prudence and less public debt to the factors that make emerging markets much less risky.
But all the participants are concerned about the winding down of the credit booms that capital inflows fueled. Wilson worries about economies with current account deterioration, easy monetary policy, above-target inflation, weak linkages to the recovery in the developed markets and institutions of questionablestrength. He cites Turkey, India and Brazil as countries that meet these criteria. Similarly, Taylor lists countries with relatively rapid expansion in domestic credit over the 2002-2012 period, and Brazil and India appear vulnerable on these dimensions as well.
Another analysis of the determinants of international capital flows comes from Marcel Förster, Markus Jorra and Peter Tillmann of the University of Giessen. They estimate a dynamic hierarchical factor model of capital flows that distinguishes among a common global factor, a factor dependent on the type of capital inflow, a regional factor and a country-specific component. They report that the country component explains from 60 – 80% of the volatility in capital flows, and conclude that domestic policymakers have a large degree of influence over their economy’s response to capita flows.
But are “virtuous” policies always rewarded? Joshua Aizenman of the University of Southern California, Michael Hutchison of UC-Santa Cruz and Mahir Binici of the Central Bank of Turkey have a NBER paper that investigates the response in exchange rates, stock markets and credit default swap (CDS) spreads to announcements from Federal Reserve officials on tapering. They utilize daily data for 26 emerging markets during the period of November 27, 2012 to October 3, 2013. They looked at the response to statements from Federal Reserve Chair Ben Bernanke regarding tapering, as well as his comments about the continuation of quantitative easing. They also looked at the impact of statements from Federal Reserve Governors and Federal Reserve Bank Presidents on these topics, as well as official Federal Open Market Committee (FOMC) statements.
Their results show that Bernanke’s comments on winding down asset purchases led to significant drops in stock markets and exchange rate depreciations, but had no significant impact on CDS spreads. There were no significant responses to statements from the other Fed officials. On the other hand, there were significant responses in exchange rates when Bernanke spoke about continuing quantitative easing, as well as to FOMC statements and announcements by the other policymakers.
The countries in the sample were then divided between those viewed as possessing “robust” fundamentals, with current account surpluses, large holdings of foreign exchange reserves and low debt, and those judged to be “fragile” due to their current account deficits, small reserve holdings and high debt. Bernanke’s tapering comments resulted in larger immediate depreciations in the countries with current account surpluses as oppose to those with deficits, more reserves and less debt. Similarly, Bernanke’s statements led to increased CDS spreads in the countries with current account surpluses and large reserve holdings, while lowering equity prices in countries with low debt positions. The immediate impact of the news regarding tapering, therefore, seemed to be tilted against those with strong fundamentals.
The authors provide an explanation for their results: the robust countries had received larger financial flows previous to the perceived turnaround in Fed policy, and therefore were more vulnerable to the impact of tapering. Moreover, as the change in the Federal Reserve’s policy stance was assimilated over time, the exchange rates of the fragile nations responded, and by the end of the year had depreciated more than those of the more robust economies. Similarly, their CDS spreads rose more. By the end of 2013, Brazil, India, Indonesia, South Africa and Turkey had been identified as the “Fragile Five.”
What do these results tell us about the impact on emerging markets from future developments in the U.S. or other advanced economies? There may be a graduated response, as the relative standings of those nations that have attracted the most capital are reassessed. However, if capital outflows continue and are seen as including more than “hot money,” then the economic fundamentals of the emerging markets come to the fore. But financial markets follow their own logic and timing, and can defy attempts to foretell their next twists and turns.
I was surprised at first by Aizenman, Hutchinson, and Binici’s findings that countries with strong fundamentals were more sensitive to news of tapering than those with weak fundamentals. Though their explanation that countries with strong fundamentals experienced stronger capital inflows prior to tapering makes sense, I wonder what their results would look like if they controlled for capital inflows.
Their study also reminded me a lot of Fratzscher’s paper on exchange rate movements during crises that found that countries with weak fundamentals were more heavily impacted by the US crisis in 2008. Interestingly enough, it now seems like countries with strong fundamentals are more heavily impacted by signs of a US recovery indicated by tapering.
The fear and consequence of rapid capital outflow caused by the Fed tapering is interesting considering the conclusions we saw in class that “…there have been a number of studies that indicate that opening a country’s stock markets to foreign investors does result in more growth…” since the longer lasting causal effects of capital flow are most valuable to a nation; I would think that if a country’s fundamentals are strong and the private sector functions normally, there would be a relatively low impact on this aspect of capital outflow.
Of course, though, there are a number of other problems EM economies deal with, as evaluated by Aizenman, Hutchinson, and Binici that are affected by the fluctuations of the dollar (strengthening in this case). I, like Sophia, also found their results interesting but their explanation does make perfect sense. I wonder how long we will continue to see the effects of QE in the US internationally as we move forward with our economic recovery.
Recent data and report have suggested that US economy is slowly recovering from the 2008 crisis. Thus, when Fed’s chair Yallen decides to cut QE, it seems to me a sign of confidence in the US economy rather than a sign of incompetence usage of QE. Furthermore, although Aizenman, Hutchinson, and Binici’s explanation on countries with strong fundamentals experienced stronger capital inflows prior to tapering seems to be supported with evidence, it is questionable whether their results would change when controlled with the factor of capital inflows.
This post reminds me of the recent post on whether it will be possible to restructure growth patterns by raising inequality. Specifically, how can U.S. policymakers increase the savings rate without damaging the recovery to the financial crisis.
As this blog post explains, the Fed’s reduction in asset purchases has already led some countries to raise their interest rates in hopes of preventing a “sudden stop” in foreign capital. But in the context of global economic recovery, it may not be possible for countries seeking higher growth rates to maintain such high interest rates. Despite the fact that fixed exchange rates are no longer as common as they once were, might the Fed’s “tapering” policies lead to some form of a second-generation crisis, if countries are forced to lower interest rates and devalue their currencies?
I think the current economy is weakening, especially in Indonesia.
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if capital outflows continue and are seen as including more than “hot money,” then the economic fundamentals of the emerging markets come to the fore. But financial markets follow their own logic and timing, and can defy attempts to foretell their next twists and turns.