Emerging markets’ dollar flight: the Fed is not to blame, and it knows it
Nicholas Spiro says domestic weaknesses bear the lion’s share of the blame for market turmoil in Argentina, Turkey, Brazil and South Africa, so don’t expect the Fed to adjust the pace of its rate increases to suit them
Every now and again, a prominent policymaker takes the bull by the horns and tackles a hot-button issue in financial markets.
This month, Urjit Patel, India’s central bank governor, waded into the debate surrounding the sharp sell-off in emerging markets by writing a column in the Financial Times, in which he warned that the turmoil could intensify in the coming months due to a sharp reduction in the pool of US dollars heading overseas.
A so-called dollar liquidity squeeze is likely to suck more foreign capital out of developing economies, Patel claims, because of the “double whammy” of a huge increase in America’s budget deficit, following the enactment of President Donald Trump’s trillion-dollar tax cuts, and the unwinding of the Federal Reserve’s US$4.5 trillion balance sheet.
The simultaneous surge in US debt issuance to pay for the tax cuts – which will gobble up a larger share of dollar liquidity – and withdrawal of dollar funding by the Fed poses a far bigger threat to emerging markets, Patel argues, than the pace at which interest rates are raised, the current focus of attention. To avert a full-blown crisis in developing economies stemming from a shortage of dollar funding, India’s central bank governor says the Fed should unwind its balance sheet at a slower pace.
Leaving aside the issue of whether the Fed should heed Patel’s warning, it is refreshing to hear a leading policymaker – especially one from a major developing nation – point out that the Fed’s interest rate policy is not to blame for the sell-off in emerging markets.
If Patel has a culprit in mind, it is Trump and the Republican-controlled Congress, whose reckless fiscal policies risk hoarding dollar liquidity, restricting capital flows to developing nations.
Yet, while Patel is right to argue that the sharp declines in emerging market asset prices have little to do with Fed rate increases – inflows into emerging market bond and equity funds reached a record high of almost US$200 billion last year despite three rate hikes – he fails to mention the role of domestic factors, which are more important than external ones in explaining much of the current selling pressure.
While this year’s surge in the dollar and Treasury yields may have triggered the turmoil in emerging markets, it is the common vulnerabilities in several leading developing economies which account for the bulk of the price declines in the past two months, causing the entire asset class to come under strain.
As was the case during the so-called taper tantrum in 2013, markets are penalising countries with large current account deficits or a heavier reliance on external sources of financing. This is why Argentina and Turkey, which are running current account shortfalls of between 5 and 6 per cent of gross domestic product, have been hardest hit, with their currencies losing a staggering 36 per cent and 18 per cent respectively against the dollar so far this year.
Moreover, vulnerabilities tend to beget more vulnerabilities, drawing attention to other areas of weakness in emerging markets.
The latest country to come under severe strain is Brazil. While its current account deficit is less than 1 per cent of GDP, its government’s poor handling of a national truckers’ strike accounts for most of the nearly 12 per cent fall in the real, Brazil’s currency, since early April. The government reimposed controls on petrol prices, reminding markets of Brazil’s populist past, just as a presidential election campaign gets under way in which populist candidates are the front runners.
South Africa, which runs a larger current account deficit, is also suffering mainly because of homegrown problems. Last Tuesday, a report by the country’s statistics office revealed that, in the first quarter of this year, South Africa’s economy contracted at its sharpest pace in almost a decade, puncturing the optimism generated by the departure of former president Jacob Zuma earlier this year.
These country-specific weaknesses have become more apparent as financial conditions begin to tighten. They also exonerate the Fed from most of the blame for the current turmoil in emerging markets, making it less likely that America’s central bank will feel compelled to delay the withdrawal of stimulus.
Jerome Powell, the new Fed chair, suggested as much in a speech in Zurich last month when he rightly noted that US monetary policy has not been the most important determinant of capital flows to emerging markets.
So on Wednesday, when the Fed is widely expected to raise rates for the second time this year, it is unlikely that the woes of developing economies will figure prominently in the central bank’s deliberations.
Nicholas Spiro is a partner at Lauressa Advisory