Does Fed policy threaten global financial stability?
Headlines seem to think so. A few Emerging Markets currencies are taking it on the chin, the entire world risks “contagion,” and it’s all because the Fed is slowing quantitative easing (QE) bond buying. They say QE propped up growth there, China’s weak manufacturing print shows how vulnerable economies are to the program’s end, and currencies throughout the developing world are reeling as foreign investors panic.
Thing is, if that’s all true, it means the Fed is responsible for all of the following: A decade of economic mismanagement in Argentina. The thuggish, tyrannical rule of Recep Tayyip Erdogan. The firestorm in the Ukraine. China’s decision to destroy steel mills and crack down on shadow banking. South Africa’s over-dependence on metals and mining. Russia’s on oil.
Does anyone really think Ben Bernanke was that powerful?
We’ve said for a while the narrative about QE hot money propping up Emerging Markets—and certain catastrophe when it ends—is a ghost story. One, if developing economies were fueled by massive amounts of foreign money during the age of QE, we’d probably have seen rip-roaring growth—not the slowdown that actually happened. Ditto for asset prices—Emerging Markets stocks haven’t wildly outperformed during this bull, they’ve markedly underperformed. There is scant evidence Emerging Market stocks were artificially inflated by QE. Two, the much-ballyhooed hot money flows are largely myth—foreign portfolio investment inflows were high when QE began, but that was mostly a reversal of huge outflows during the financial crisis. Since then, they’ve fallen off and are largely in line with historical norms (and have often turned negative over the past couple years).
So, then, what of the current currency rout? It isn’t a categorical issue—it’s specific to countries with big fundamental problems. There are 21 countries in the MSCI Emerging Markets index—21 currencies with 21 unique sets of political and economic drivers. 23, if you count the two Frontier Market hot spots, Argentina and Ukraine. Most developing-world currencies are just fine: The troubles are isolated to Argentina, Turkey, the Ukraine, South Africa and Russia.
Argentina is a mess. Since defaulting in 2001, it hasn’t been able to raise a dime on international capital markets. President Cristina Fernandez’s socialist policies—including price controls and the seizure of foreign-owned oil interests—have chased off most private investors. The central bank has depleted forex reserves trying to keep the peso afloat, but inflation is still off the charts. This week, with reserves down to $29 billion, officials gave up trying, allowing market forces to take over and drive down the peso. Now, they claim it’s at an “acceptable level” and are trying to keep it there by limiting each citizen’s foreign online purchases to two a year to limit the exodus of capital.
Turkey is another basket case. Its markets—stock, bond, currency—have struggled since last spring amid severe political unrest. It started with massive protests against Erdogan’s increasingly authoritarian rule. Now he’s tied up in a corruption scandal, and his solution appears to be purging 2000 police officers and 96 judges—including those spearheading the corruption inquiry—and replacing them with loyalists. Members of his AKP party beat the opposition’s second command to a bloody pulp in Parliament on Thursday. He’s in the hospital now. The Constitution has been all but abandoned, and the economy is at a standstill. It’s an election year, and Erdogan’s popularity is at an all-time low, but the system near-guarantees his victory. Freaked investors are leaving in droves, and on Tuesday, the central bank tried to address the issue with bad monetary policy: It said it would let short-term rates rise from 7.75% to 9% on random “exceptional” days. Confusion reigned. The lira tanked.
South Africa and Russia don’t have quite so acute political issues (well, Putin, but it’s all relative). But they do have extremely commodity-dependent economies. South Africa’s fortunes largely depend on metals and mining—locked in a deep slowdown after years of heavy investment created a supply glut. Energy, meanwhile, is the last functioning leg of Russia’s economy, and the shale boom hasn’t been kind—Russia doesn’t have the high oil prices it needs to keep state revenues flush. With economic opportunities fading—and Putin’s heavy hand a constant threat to private property rights—investors are looking elsewhere. (Incidentally, some pundits throw the Ukraine into this supposedly QE-taper plagued bunch. Yet their currency hasn’t slid noticeably despite the fact there is noticeable turmoil politically. It would not surprise me to see the Ukraine come under some pressure—it’s not good evidence of QE-taper plague, either.)
These are big, bad fundamental reasons for these nations’ currencies to slide—and they’ve been sliding for a while. It’s just more acute this week, thanks largely to those wacky monetary policy moves in Argentina and Turkey—markets are capitulating, if you will.
If these issues are confined to the world’s Submerging Markets (trademark pending), why do even some of the healthiest Emerging Markets like South Korea and Mexico seem to be going along for the ride? Most likely, sentiment. Like stock markets, currency markets can swing on emotions in the short term. Concerns over a handful of reeling developing-world currencies can spook investors, and that fear can drive volatility elsewhere, regardless of how fundamentally strong the country otherwise is. That’s just how markets work.
Over time, however, markets weigh fundamentals, and there is no fundamental driver for an Emerging Markets currency contagion, à la 1997’s Asian currency crisis. Then, Indonesia, Thailand and South Korea all had pegged currencies and high dollar-denominated debt. When the yen weakened relative to the dollar, these nations’ central banks had to intervene, selling off forex reserves to keep their currencies afloat. Speculators bet Thailand wouldn’t make it, and they were right. Officials devalued the baht, freaking foreign investors in countries with similar financial situations. Indonesia and South Korea nearly went bankrupt before receiving nearly $100 billion in IMF loans.
Today is different. Outside China and Malaysia, Emerging Market nations don’t have fixed exchange rates, and most nations have big forex buffers—nations have long-since addressed the vulnerabilities extant in the late 1990s. Some cite high current account deficits, but those don’t mean much in this (or any economic) context—coincidence isn’t causality. On the whole, the world has learned from 1997, and countries are nicely insulated.
In the immediate term, volatility could very well continue—especially if things stay messy in Turkey and Argentina. Last July and August, it took India’s rupee a few months to stabilize after it was roiled by political instability and haphazard monetary policy. If more central banks respond to the current volatility with monetary policy, the troubles could spread. But monetary policy moves are impossible to forecast with precision—we can only weigh them after the fact, as markets did this week in Turkey and Argentina.
But what matters more is this: Most Emerging Markets are on fine fundamental footing, growing on a bedrock of domestic investment and demand, with some buoyed by free-market reforms. This is good for the world, and a big underappreciated positive for global stocks.