The US Federal Reserve’s surprise decision to continue quantitative easing (QE) was generally well received in those countries with rapidly growing and industrialising economies. They were worried that the Fed might have ended an era where cheap dollars have moved by the trillion to the so-called “emerging markets”.
But while the US continues with QE, and the pressure may be off for now, some emerging markets must be more worried than others about what happens when the Fed does say enough is enough.
The Fed’s initial statement in late May floating the possibility of an end to QE hit the markets hard. Bond yields in developed countries went up, and emerging markets currencies and stock market indices tumbling down. In particular, investors, with the expectations of rise in yields, drew their funds back to the US from riskier emerging markets.
This reversed a trend that had been in place since the stimulus began following the global financial crisis. Investors were looking for higher returns in emerging markets as interest rates dropped to historical lows in the US and other developed economies, making savings almost pointless.
It is estimated that since 2009 US$4 trillion worth of funds has moved to emerging markets. To put it simply, these capital movements were down to the availability of cheap money, created by stimulus. They were never about the emerging markets themselves suddenly become attractive investment destinations due to their own reforms.
All this meant more money was flowing in to emerging markets than was leaving in the shape of exports. In other words, availability of cheaper foreign financing allowed emerging economies to import more than they can export.
Those countries where foreign capital is necessary to finance a trade deficit are particularly vulnerable to changes in developed economies (and especially the US). Some big hitters fall into this category: Brazil, Turkey, Mexico and South Africa, among others.
Another complexity is the rise in borrowing costs. Most households in emerging countries relied on cheap money to borrow and increase their consumption. Possible phasing out of the monetary stimulus would push US bond yields higher and, as these bonds are used as benchmarks for pricing, the cost of borrowing will increase in emerging markets. This may lead to problems in rolling over debt for governments and households alike and prompt a surge in bad loans.
Still another complication for the emerging markets is the possible rise in inflation caused by currency depreciations. Increasing the interest rates by central banks may be inevitable but may not be the most desirable policy when these economies struggle with capital flights and increasing borrowing costs.
But is it all bad news for the emerging economies? Certainly the good news is that the US economy, the biggest in the world, is showing positive signs of recovery. US growth prospects, coupled with similar trends in Japan and the EU (all are expected to perform better in 2014), means demand for emerging-market exports will increase. A devalued local currency will also make exports more competitive for emerging markets leading to sell more and buy less.
However, not all the emerging markets are in the same boat. The ones with high current account deficits financed with foreign capital and with growth driven by consumption would certainly struggle to adapt in a post stimulus era. For Brazil and Turkey, the warning signs are there. Those countries with strong trade sectors and fewer rivals for the products they export - think China or Malaysia - will survive by utilising the demand in developed economies.
The overwhelming feeling in emerging markets following the Fed’s decision to delay stimulus tapering was one of relief. Although we stock markets and currencies in most emerging markets rose sharply last week, fundamentally nothing has changed.
The Fed will ease off the monetary stimulus sooner or later, once they observe stronger signs of employment. But this unexpected delay has given policymakers in emerging markets some valuable time to tackle underlying economic problems and apply the reforms that will reassure investors in the long term.
For now, the emerging markets will continue to emerge. But the threat of a post-QE era still hangs over them.