Much like QE’s taper, this tapir awaits his world debut. Source: Hulton Archive/ Getty Images.
We’ve opined many times tapering QE will be a positive for markets—not just in the US, but globally—as yield curves steepen, including in Emerging Markets (EM), creating underappreciated potential for growth. But for many, this is hard to see. For example, some investors think US QE is pumping up EM growth, and when it stops, EM economies will tank—a fear likely exacerbated as some EM currencies have come under fire with escalating taper talk. In our view, though, this confuses coincidence with causality. For one, QE isn’t doing much for EM, just as it isn’t doing much at home—data show foreign capital inflows in the age of QE are more muted than folks assume. More broadly, investors are seemingly mistaking fundamental weakness in some EM nations with broad regional taper vulnerability—another example of too-dour expectations. They’re likely followed by upside surprise, lifting stocks.
One country’s monetary policy can indirectly impact another’s markets—especially a country as big and globally integrated as the US. For one, some countries have taken advantage of ultra-low US rates to borrow in dollars. But beyond that, there isn’t much evidence massive amounts of QE money are underpinning Emerging Markets—if they were, exchange rates would have risen in tandem with the Fed’s balance sheet. Some countries’ currencies did strengthen to various extents, but there isn’t a discernible regional correlation. Thus, the reverse likely holds as well—foreign money might be leaving some Emerging Markets, but the outflows are likely tied more to specific local risks than the end of QE.
Take the Ukraine. Having historically relied on Russia for much of its business after the USSR broke up, the Ukraine’s economy today is uncompetitive—high corruption and price controls are just two of its structural issues. It also faces an ever-present threat of trade war with Russia, which is pretty sore over the EU’s attempts to adopt its Crimean buffer state. More importantly, it has high dollar-denominated debt and a currency pegged to the dollar, which in the past has ended badly for Emerging Markets. Consider the late 1990s’ “Asian Contagion”: Many Asian nations had dollar-pegged currencies and used the favorable exchange rate to borrow cheaply in the US earlier in the decade. When the party ended, they first defended the pegs, only to drop them when reserves near-depleted. That meant floating their currencies at suboptimal times. They almost instantly devalued, exacerbating economic weakness and making foreign debt near-impossible to service, requiring Thailand, Korea and Indonesia to go hat-in-hand to the IMF.
Now, Ukraine is in a similar position. Its forex reserves have dropped to $21.7 billion, and the country owes $10.8 billion in dollar-denominated debt service through 2014. As a result, the Ukraine is extremely vulnerable to foreign capital flight—reserves cover about three months’ worth of imports, and domestic growth is stagnating, limiting wealth creation potential. But if and when foreign investors do flee, it won’t have much to do with tapering. Ukraine’s fundamental risks would be strong enough to drive them away with or without QE.
This weakness isn’t an inherent trait among all EM nations—many have free-floating (or fixed-floating) currencies, robust forex reserves, current account surpluses and competitive economies, like South Korea, Mexico, Malaysia and the Philippines, to name a few. Which means even if some foreign capital were to depart, whatever the reason, their currencies and economies wouldn’t be at great risk. Their economies are dynamic enough to grow with or without a little extra foreign capital. This is likely why many stronger EM economies have been largely absent from headlines decrying alleged taper-talk-inspired runs on EM forex reserves. It’s countries like India, which have structural competitiveness issues, that have been hit the hardest (and India’s blow seems more tied to erratic monetary policy decisions, in our view).
Stronger Emerging Markets should keep growing and thriving on good fundamentals and innate competitive advantages—factors that should continue attracting domestic and foreign investment whether or not QE ends. Consider Mexico, with its ultra-competitive labor costs, geographic advantages and burgeoning free-market reforms. Or the Philippines, with its above-peer growth rates, benign inflation, $70 billion forex reserves and high, profitable loan growth. These are two examples, but reform and development are progressing region-wide. Progress might be slower in some areas than others, but even incrementally opening-up economies promote increased investment and growth.
If anything, investment could very well accelerate after QE ends! Tapering would allow the US yield curve to widen, and EM yield curves likely follow—a bullish development for all markets. Steep yield curves indicate healthy economies and support growth. They’re also a powerful investment incentive—banks lend more freely, and businesses get much more cash to plow into growth-oriented endeavors. Consumers benefit, too, as capital permeates the entire economy.
Higher growth in EM in turn likely provides stronger revenue streams for developed markets—further spreading tapering’s positive impact. And stronger revenues mean continued profit growth globally—the more investors realize this, the more they’ll pay for future earnings growth. Though investors are skeptical now, with each unexpected, positive development, their market outlook should gradually align more and more with a healthy global economic reality, driving markets higher still.