miércoles, 29 de enero de 2014

Will the BRICS come tumbling down?

After the Fed invented QE (quantitative easing), concerns arose about unintended consequences. Inflation is one that hasn't proven a problem. Another concern is the possible formation of asset bubbles. The behavior of international financial markets in recent days suggests that the concern about bubbles is justified.

In today's global financial markets, US monetary policy has consequences for other countries, not just the US. The massive injections of liquidity that are the essence of QE seem to have done more to boost currency values in emerging markets than to boost lending in the US.

As the Fed has begun exiting from QE by slowly reducing its purchases of Treasury bills and asset backed securities in the US financial markets (the famous "tapering"), investors have reconsidered their love affair with financial investments in emerging markets. Judging by the abrupt devaluations suffered by the currencies of major emerging markets this month, investors have re-discovered risk aversion.

It's not just tapering that has investors nervous. The near default on US$500 billion in debt obligations in China spooked the markets. It's no secret that the Chinese banking system is far from sturdy. The rapid rise of a shadow banking system (estimated to be as much as 60% of GDP) brought the Chinese authorities their own "Lehman moment". They opted not to take the chance of seeing what the consequences of a default would be.

Corruption scandals in Turkey added fuel to the flames. When you start to look, there's plenty of reasons to wonder how solid economies with large government and current account deficits might be if portfolio investment isn't pouring in.

"A rising tide lifts all boats". So has a world awash in liquidity strengthened the currencies of emerging markets. Now that there's not quite so much liquidity, investors are beginning to differentiate amongst emerging markets. Turkey is not the same as Mexico. Neither is Argentina. Between January 2 and January 28, the Turkish Lira devalued 6.2%. The South African Rand devalued 6.1% and the Russian Ruble, 5.8%. The Argentine Peso plunged 22.8%. The Mexican peso hasn't escaped the backlash. It's devalued 2.5% in the same period.

That the differentiation process is beginning is not to say that it's well developed or particularly sophisticated: a former economist for the IMF turned hedge fund manager has considered turning the "Fragile Five" into the "Sorry Six" by adding Russia to Turkey, Brazil, India, South Africa and Indonesia. He's also quoted in the New York Times as suggesting avoiding currencies with four letters, like the Brazilian real, the Turkish lira, the South African rand, or the Mexican peso. If that was not a jest and it's indicative of fund managers' attitudes, it doesn't instill much confidence that investors have a deep understanding of the differences amongst emerging markets.

In addition, the peso is amongst the most liquid and deep markets for emerging market currencies. That means that when investors want cash, they sell Mexico, regardless of what's happening in Mexico. So, no matter how sound Mexico's policies, the peso can get battered, at least temporarily.

This afternoon, January 29, the FOMC announced that, as expected, it will continue to reduce its asset purchases by US$10 billion a month. Purchases under QE will have fallen from US$85 billion a month (September 2012 - December 2013) to US$75 billion in January 2014 to US$65 billion in February. The Fed's explanation of its decision and guidance on future policy talked only about US growth and inflation. There was NO reference made to the implications of Fed decisions for emerging markets. Buckle your seat belts; it's likely to be bumpy.

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