During the early days of the global financial crisis around ten years ago, the U.S. Federal Reserve launched quantitative easing (QE) programmes and slashed its benchmark interest rates to near-zero levels, with the Fed funds rate targeting at a range of zero to 0.25%.
Since then, the U.S. central bank’s balance sheet has grown significantly in size. Total assets have quadrupled from US$869 billion on 8 August 2007 to well over US$4 trillion at present. In late 2014, amid a strengthening economy, the policy-setting Federal Open Markets Committee outlined its approach to monetary policy normalization, and then in December 2015 it raised interest rates by 25 basis points. At its recent June meeting, the Federal Reserve unsurprisingly pressed the button again to raise interest rates by 25 basis points to a range of 1.75% to 2%, marking the seventh rate hike of the present tightening cycle and the second this year.
With the major central banks across the globe creating massive amounts of new money in the past decade and pushing down bond yields in U.S. Treasuries and other safe assets, private investors turned to riskier but higher return avenues to park their investments. These included the emerging markets, which have experienced large inflows of foreign capital, exchange rate appreciation and an equity market boom.
So when the Fed’s then Chairman Ben Bernanke merely hinted at the idea of tapering QE in 2013, investors around the world panicked and pulled their money out of the emerging markets, resulting in sharp adjustments in asset prices and currency values. As the Federal Reserve is expected to continue its normalisation process by raising interest rates and shrinking the balance sheet further, some fear a repeat of this “taper tantrum” of 2013.
And this time, concerns about trade protectionism are adding to the worries, as exports are an important engine of growth for many emerging markets.
As a result of a stronger U.S. dollar and higher U.S. Treasury yields – most notably the 10-year Treasury yield’s breach of the 3% threshold for the first time in over four years – the attractiveness of the emerging markets appears to be diminishing. The emerging markets saw in May their biggest portfolio outflows in 18 months, according to the Institute of International Finance, a Washington-based global industry association. A total of US$12.3 billion of bonds and stocks were sold by foreign investors during the month. (The previous significant outflow from emerging markets occurred in November 2016, right after the election of Donald Trump to the White House.)
By region, the biggest outflows were US$8 billion from Asia, and US$4.7 billion from Africa and the Middle East combined. Jitters among investors resulted in heavy selling of emerging market currencies. Due to local issues such as rapid inflation and investor scepticism about central bank policies, Argentina and Turkey were among the hardest hit with both the peso and lira repeatedly hitting record lows against the U.S. dollar. Attempting to contain the crash, their central banks raised interest rates, with the Argentine government calling on the International Monetary Fund (IMF) for help.
Against this background, volatility in emerging markets has heightened as the Federal Reserve signalled that two more rate hikes are likely in 2018. However, a large-scale meltdown in the emerging markets or a repeat of the 2013 taper tantrum is unlikely, at least for now.
First, growth in the emerging markets has firmed up, thanks to a global economic upswing that the IMF described as “broader and stronger” in its World Economic Outlook report in April (Figure 1). Many commodity exporters have in fact benefitted from the recovery of energy and metal prices. Mainland China, an important source of demand for many emerging markets, has maintained steady growth and looks ready to support its economy if needed. At the April meeting of the Politburo, Chinese leaders called for steps to “expand domestic demand to ensure the stability of the macro economy.”
Second, fundamentals in most major emerging markets remain largely intact. Brazil, South Africa and Indonesia – which were included by Morgan Stanley in the “Fragile Five” basket in 2013 due to concerns on their external position and vulnerability to capital outflows – have seen deficits in their current accounts narrow markedly (Figure 2).
Third, policy frameworks in many emerging markets have improved, and their present better public finance management and greater exchange rate flexibility can help cushion the effects of external shocks.
While the emerging markets as a whole should be able to pass this round of stress tests, those with weak external positions and large financing needs will be more volatile when the tide of easy money recedes. As Hong Kong is a small, open economy highly dependent on international trade and finance, and subject to spillovers from the external environment, there is reason to worry about a less satisfactory result for the domestic economy in the next round of stress tests because of the anticipated poor performance of such economies.