Investors, especially in emerging markets, have had a torrid start to the year. Fears that the US Federal Reserve (Fed) may be withdrawing the quantitative easing (QE) punchbowl through “tapering” hit stock markets and risky assets worldwide. A relief rally in the second week of February helped calm nerves. However, the complacency that marked previous years has been shattered. Janet Yellen, the new Fed chair, unsurprisingly told emerging market countries that the Fed will act in the interests of the US rather than worry about the world. For emerging market investors, the calm sea has suddenly turned choppy and they need to re-evaluate whether to batten down the hatches or continue at full sail.
History has seen emerging markets usually experiencing economic storms after the Fed embarks on tighter monetary policy. Certainly there are several other factors at play, including fiscal and political, that have contributed to the crises, but the common thread binding them is dearer money. The Latin American crisis in the early 1980s that led to sovereign bailouts and a lost decade for the region occurred after the US policy was tightened after the oil shock of 1979. The Mexican crisis in 1994 came soon after the Fed started hiking interest rates. The Asian crisis of 1997 came after a period of tight monetary policy with the Fed funds rate rising from 3% in January 1994 to 6% in May 1995.
Moreover, it is not only the emerging markets that swoon when monetary policy is tightened. Asset bubbles of all shapes and sizes have a nasty habit of popping upon monetary tightening. The dot-com bubble burst soon after Alan Greenspan started raising rates in April 1999. The latest and the greatest credit bubble popped in 2007 after the Fed had finished hiking rates in November 2006.
However, the current tapering by the Fed, that is, reducing purchases of US bonds to $65 billion a month from the initial $85 billion, may seem like the flapping of a butterfly’s wings to a bemused emerging market investor. After all, tapering signifies better economic prospects for the US, which, in turn, should be good for the world. Moreover, the QE is only going to be rolled back very gradually and interest rates are still expected to remain at near-bottom, so easy monetary conditions are likely to continue for quite some time.
While it is true that interest rates are unlikely to change in the near term given the sluggishness of the global recovery, it is only half the picture. The missing half is the debt engendered by monetary policy. Normally, debt rises to a point where it is just sustainable at the current interest rates; often it rises beyond the point as bull runs culminate in manias. Therefore, any increase in rates, even if it is small, leads to distress.
Take the example of someone deciding on a mortgage. If interest rates are low, he will take a bigger loan to buy a bigger house since the proportion of EMIs to take-home salary is manageable. A subsequent rise in interest rates can cause distress as EMIs balloon, especially if the person took too large a mortgage assuming a large future salary increase.
Emerging markets behave in a similar fashion, gorging on debt in a low-interest world only to suffer when rates rise. The late US economist Hyman Minsky showed that financial capitalism was prone to manias and crashes due to the propensity of debt to increase beyond the point of sustainability. Lower interest rates only delay the day of reckoning until debt climbs to a new level. This is captured perfectly in Graph 1, which shows ballooning US private sector debt (households and non-financial corporations) as interest rates have declined in the last three decades. Easy money policies pursued after 2008 have led to similar credit booms globally.
Therefore, as the Fed “tapers”, the rising tide of liquidity that lifted the emerging markets after the bursting of the credit bubble is receding. Although the Fed may not raise interest rates, the very action of reducing or eliminating bond purchases will cause yields to rise in the US treasury market and consequently in other markets, given that treasuries function as the global yield benchmark. Even though the knock-on effect yields may be small initially, investor nervousness can cause yields to spiral higher, leading to eventual distress. The January sell-off offered a preview of the impact that jittery investors can have despite a steady policy. Moreover, as debt has grown to new highs in the US (and other developed markets), a rise in yields can also lead to problems closer home. Any such turbulence will be carried over to emerging markets through financial markets as was the case in 2007-08.
Additionally, as yields rise in the US (and other developed markets), the pressure to chase returns in emerging markets will abate somewhat, with the market refocusing on economic fundamentals and politico-legal risks. Turkey and Ukraine are two recent examples where economic vulnerability and political risk have had investors running scared.
Given the big picture, how should an emerging market investor negotiate the increasingly choppy waters? Helpfully the Fed itself has constructed a vulnerability index of 15 emerging markets. This is based on three indicators of indebtedness (government debt, bank credit and external debt), two of which indicate capital flows (current account balance and forex reserves) and inflation. Emerging markets with higher debt levels and dependence on foreign capital flows during the last few years are likely to experience a bigger correction. Based on the Fed’s ranking, the top five most vulnerable are Turkey, Brazil, India, Indonesia and South Africa (in decreasing order). Assets and currencies of these countries have already corrected to an extent. However, we are likely at the beginning rather than the end of a storm and the astute investor will be well advised to steer clear of treacherous emerging market waters.
Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word.