Great Reversal and the Fed

Rupee notes The Indian rupee has hit record lows

The minutes from the Federal Reserve's meeting show that America's central bankers broadly agree that they should "taper" or cut back their injections of cheap cash later this year if the economy improves. This paves the way for the quantitative easing (QE) programme to end perhaps by the middle of next year.

It doesn't mean that the Fed will withdraw the money that they put into the economy anytime soon or that rates will rise. They even discussed lowering their unemployment target from 6.5% so that rates could stay at 0-0.25% for longer.

There is still uncertainty about when all of this will happen. But the reaction in emerging markets was clear. More money left as the Indian rupee hit a new record low, while the Indonesian rupiah and Thai baht are at their lowest levels since 2009. Asian stock markets have pretty much erased all of this year's gains.

And it's not just affecting Asia but emerging economies around the world. The stock markets of Brazil and India are down more than 20% since the start of the year, while China and Russia have fallen by about 12%.

It started quietly in May when Fed chairman Ben Bernanke first raised the prospect of tapering, and I wrote about the potential impact of the great reversal of cash.

As with most capital outflows, a trickle can quickly become a flood. An estimated one-third of the money invested in the bond funds of the BRICs (Brazil, Russia, India and China) have been pulled out since May. During the same period, nearly $100bn has gone back into US equities.

With more signs of the beginning of the end of the era of cheap cash, investors are looking harder at where to put their money. In the past four years since the global financial crisis, $3.9 trillion has poured into emerging economies. These countries, which had looked attractive because they were growing faster than the sluggish West, now look less so as the US recovers.

It's the old adage: higher returns usually mean higher risk. Emerging economies have grown well, but they are more risky as they are developing countries which have a more volatile growth path.


The big question is whether these emerging economies can cope when the money leaves.

The most vulnerable are those with the greatest exposure to foreigners owning their debt, since that debt could be sold off which would push up borrowing costs for these countries.

According to HSBC, foreigners own about 40% of Mexico's debt market now, compared with just 2.5% in 2003. For Poland, it is 37% versus 17% then. And, in Indonesia, foreigners hold 30% now, which doubles their holding since 2009.

In absolute numbers, Brazil has most dollar loans at $287bn. But, on a relative scale, Turkey's $172bn of dollar loans equals 22% of the entire economy.

Other countries that are at greatest risk are those with large external deficits to finance. India's current account deficit, the broadest measure of trade including investment flows, is at 4.8% of GDP, while Indonesia's stands at 3.2%. It's unsurprising that their currencies have fallen so dramatically this year.

Again, it's not just in Asia. The rupee is the worst performing currency in Asia, but it jostles with the Brazilian real and the South African rand for the worst performer in the world this year. Both of those countries have struggled to cope with appreciating currencies in the past few years as cheap cash entered their borders. Now, their currencies are declining as the money leaves.

Where could this all end up?

A worst case scenario would be a repeat of the 1998 Asian financial crisis. That's when Asian economies, starting with Thailand, saw their currencies depreciate when "hot money" left their borders, and it ended up with several countries being rescued by the International Monetary Fund. As India and other countries have emphasised, they have foreign exchange reserves that can cover six months of imports, which gives them some protection.

Also, unlike the Asian crisis, this is not a shock development. The Fed was always going to end its QE programme at some point.

Better prepared?

But, here's the most worrying aspect.

The impact of the Asian financial crisis was unexpectedly global. Thailand had too much crony capitalism that ended up generating unsustainable debts that caused investors to leave. Similar problems in other parts of Asia as well as the close trade and investment ties in the region may explain why the money left. However, investors not only pulled their money from there but also from Russia, Turkey, Brazil, and Argentina, which plunged those economies into crisis in the aftermath. Argentina then ended up with the largest sovereign default in modern times in the early 2000s until Greece sort of took that title.

This time around, will investors be more discerning so that just countries with weak fundamentals lose out? Or, are emerging markets still treated largely as one investment class, so when the risk appetite recedes, they all lose?

Most importantly, are emerging economies now better prepared should the money leave?

The answers to these questions will determine whether the great reversal of cheap cash results in a crisis.

This reminds me of those who warn that the solution for the last crisis usually paves the way for the next one. Recall the criticism that the low interest rates that addressed the bursting of the 2001 dotcom bubble fed into the US sub-prime housing bubble. Now, the cheap cash injected to address that crisis may end up contributing to the next crisis - this time in emerging economies.

Linda Yueh Article written by Linda Yueh Linda Yueh Chief business correspondent

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  • rate this

    Comment number 45.

    John f H @2
    "rates up"
    Seat-belts on?

    Short-to-medium term useful in business to 'pretend' value-return from 'loans earning interest' (fixed or variable) alongside investments earning possible-&-judged dividends (and capital growth), but in equal partnership democracy all return will be understood in the end as in equity: capital (for the future) & dividends (market-driving income distributions)

  • rate this

    Comment number 44.

    Technical civilisation takes-off with accelerated entropy increase

    Wlite-escape parasitises accelerated increase in productive factors (not 'in it together') & their 'taxation' (to lowest bearable material average in what, 'educated', they like to call their 'standard of living')

    Linda notes alternating current of 'news' and 'response', the dynamo of profit-taking that fuels our 'education' etc

  • rate this

    Comment number 43.

    "..All this monetary manipulation & mismanagement has to end in tears.."
    Back in the day we used to talk about "sterilisation" whereby all the hot air injected into markets was actually removed.
    Here we have just started discussing "tapering" which is only half the story.

  • rate this

    Comment number 42.

    All this monetary manipulation & mismanagement has to end in tears - now for the "developing" countries, and in due course for the rich North. But those responsible will be safely retired by the time the poop hits the fan domestically.

    As the value of fiat currencies erodes, tangible assets like precious metals and (ironically) real estate are starting to look appealing again...

  • rate this

    Comment number 41.

    If the west is pulling the money out of emerging markets, then how can emerging markets buy western goods? - and then what is going to happen to the big exporters whose stock market valuations are based on them making their money from those emerging markets? Do we lend them the money?

  • rate this

    Comment number 40.

    China has been preparing quietly for their convertible currency to be used as one of main global currencies (if not the one to replace USD or Euro completely as the most valuable reserve currency for trade in a long run). They are very clever and knew this process should go at a pace that would not cause the sudden collapse of the US/West economy. I predict this would happen in a decade or sooner.

  • rate this

    Comment number 39.

    I wonder whether credit default swaps will play a role in the next crisis.
    Will the giant liabilities thrown up by the triggering of these swaps be dodged again.
    Who is underwriting these contracts now that AIG is out of the business.

  • rate this

    Comment number 38.

    I cannot get my head around these actions when applying exchange rates. Manipulation - funds in when the exchange rate of these countries are low sending rates up. Once exchange rate increases funds are withdrawn & afterwards countries exchange drops after the horse has bolted.Big banking profits using big money . In 2008 our exchange rate lost 40% over night presumably switched to these countries

  • rate this

    Comment number 37.

    For the moment it seems that the financial markets have swallowed up all the cheap money and are happy circulating it with a quasi return.

    keeping a good pool of low paid and unemployed high, keeps prices down.

    At some point this will manifest in a reset somewhere (2015 perhaps)

  • rate this

    Comment number 36.

    "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody." James Carville advisor to President Clinton.

  • rate this

    Comment number 35.


    For anyone wondering who/what the Fereral Reserve is and who owns it:

    This might go a long way to explaining its actions and why QE is structured so that it never reached Main Street...

  • rate this

    Comment number 34.

    Yes, the basic underlying pressure pushing gold higher is demand.
    There is high demand for gold in the East especially at this time of year.
    Also foreign governments, like the Germans are asking for their gold back (from the US). I read that this could be difficult as the US may have sold it or mortgaged against it already. Plus, the gold mining companies are scaling back their activities

  • rate this

    Comment number 33.

    Value and the return of an investment still apply despite all the other noises off.

    It is bizarre that the Fed tapering QE is creating ripples in so-called developing economies. The whole point of QE was to help Main Street USA which it never did. Now we know where it went. So much for domestic stimuli!

    The same possibly happened to our QE. Next time let's allow the banks to crash.

  • rate this

    Comment number 32.

    Given that the Fed is one of the major factors hampering the economic recovery, what they really need to do is close their doors and walk away for a while.

  • rate this

    Comment number 31.

    29. plotinus

    Nice theory but I prefer to rely on facts:

    Gold is heading East and is being paid for in dollars. The only place those dollars can go is home. The US is about to be hit by a tsunami of hot money - that's why Bernanke wants to taper.

    Wanting to do something and actually doing it are very different things.

  • rate this

    Comment number 30.

    From all that have seen about the way 2008 came about and has been handled i have no doubt that the Fed will do nothing to endanger the business models of GS ,JPM, if they are safe from major harm with tapering then anyone else on this planet doesnt matter one jot.....

    However , IMO crash is inevitable trying to predict where and how is impossible with all the manipulation that has happened.

  • rate this

    Comment number 29.

    @27 John M
    They need to try to taper & the market is testing their resolve
    Many believe they won't & this explains the fall in the dollar & the recent rise in Gold
    & as @17 Sagacity says tapering is only the start & the process is only complete when the market is sterilised of QE
    This gets to the root of whether the debt will ever be repaid.
    Hence rates go up reflecting risk

  • rate this

    Comment number 28.

    @John M - Google "stock market crash" and you'll find loads of articles from 'reputable' analysts (many of whom recommended Facebook shares ;-)). Furthermore, many apply the Uri Geller method, whereby if you forecast a crash often enough, then eventually you'll be right and labelled a guru, "the one who saw it coming". Anyway, I have to be an optimist, the alternative is no fun :-)

  • rate this

    Comment number 27.

    25. Plotinus "They need to try".

    I take your point but they already floated the idea and got their fingers burned in no uncertain terms. To actually do it will be to invite disaster, AIMHO, of course.

    26. Daniel Bunbury

    I admire your optimism ;o)

  • rate this

    Comment number 26.

    @John M - Equity markets will not crash, but they'll probably drop 10 to 15%, then recover. Every investor knows tapering is coming soon, probably in September, so much of the 'fear' has already been factored into the prices. China won't "dump" UST reserves because it would be financial suicide for China to cause a US default. QE will taper, markets will drop, then everyone will jump on the deals.


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