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By Amer Bisat, partner at Traxis Partners
Emerging markets are in for a rude awakening if – or shall we say, when – the major central bankers reverse their super-easy monetary policy stance. The shock will almost certainly be painful. But will it be crisis-inducing? My best guess is that the answer is no.
Let's, at the outset, get the bad news out of the way. Tighter global monetary conditions are bad for EM – pure and simple.
Consider, first, the "real economy" linkages. Global rate shocks are more-often-than-not engineered by the major central bankers to slow growth in their economies (taking out the proverbial punch ball when the party becomes too rowdy). Weaker global growth rapidly translates into weaker EM exports – a crucial driver of EM growth. Moreover, if, as is often the case, higher rates lead to lower commodity prices, the all-important commodity-exporting EM countries naturally also feel the pinch.
But, important as the real linkages are, financial ones are even more so. EM countries are, almost by definition, capital importers. Over the past three decades, EM's renewed access to "foreign savings" was key to their growth out-performance. Foreign capital, though, is attracted to EM precisely because rates of return on EM investments are high relative to those in the developed world. Anything that causes that return differential to narrow (including, higher global developed world rates) would, all things the same, lead to a slowdown (or, at the limit, a reversal) of inflows. At the extreme, a "sudden stop" of capital flows can become (and has, in the past, been) the proximate cause for many an EM crisis.
That EM gets hurt by higher global rates is borne out by history. Since the early 1990s, we've experienced three global interest rate shocks. The first two (1994 and 1999-2000) were followed, in short order, by a number of EM financial crises. The third episode (2004-07) caused a series of violent market wobbles in EM but, strikingly, no crises ensued. In fact, after every rate-spike wobble during that period, EM asset prices always recovered and, if anything, made subsequent highs.
So where does this leave us now? The reversal of QE will almost certainly create a headwind for EM asset prices. EM currencies, as they should, will take the brunt of adjusting to the worsening balance of payments occasioned by weaker global growth and the slowing down of capital inflows. Local interest rates will mirror the selloff in global rates with yield curves bear-flattening. In turn, worsening domestic EM growth (as well as the bear flattening of the yield curve) will hit equity markets and contribute to the widening of sovereign spreads.
But, the more interesting question here is whether the global rate shock will be "just" painful or will it be devastating? Put differently, will higher global rates be absorbed (as they were in 2004) or will they trigger a vicious cycle that metastasises into full-fledged crises (à la 1994 and 1999-2000)?
My judgement is that we will experience the more benign outcome. I say that for three reasons.
First, the impact of higher rates on global growth may not be as severe this time around. After all, what we're likely to see is the normalization of G3 monetary policies rather than a move to a restrictive stance. Global monetary policy, in other words, will remain easy – and conducive to growth – for years to come.
Second, EM's balance sheets are significantly healthier today than they were in the 1990s: public indebtedness is much lower and international reserves are much higher. EM countries can afford to (and likely will) engage in counter-cyclical policies that blunt the shock of higher global rates.
Finally, while trade with the developed world is indeed key to the EM growth story, it no longer is the only game in town. Domestic demand and intra-EM trade are important (and relatively new) chapters in the EM-growth story – dynamics that are relatively less impacted by global macro conditions.
Long story short: when QE is reversed, it will certainly feel ugly. But when inside that dark tunnel, one should not lose sight of the light at its end. The EM story is a secular one that will eventually be measured in decades not years. The cyclical shock from QE's reversal may well be painful. But the eventual recovery will be just as likely.
Related reading: Guest post: End of QE2 could be bad for Asia, beyondbrics Guest post: EM assets “priced to perfection”, beyondbrics Global economy: in a tight spot, ft.com End of QE2 sets tricky path for emerging nations ft. com Oil at $120: EMs hit hardest, beyondbrics EM rally: nice while it lasts, beyondbrics Carry trade=quantitative easing, FT alphaville
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