Money and its dislocations
- 29 January 2014
- From the section Business
Is the world ready for the end of the era of cheap money? It's not just what the Fed says about QE, but interest rates that will matter for the recovery for the US and the extent of the dislocations for emerging economies.
For emerging economies, they have seen money leave their borders and falls in their currencies.
The Fed meeting today, the last under Chairman Bernanke, is widely expected to cut back further on monetary stimulus. Since he first signalled it last May, to when the "taper" was first announced last December, emerging economies have been braced for the inevitable.
But, the emergency actions and rate hikes from Turkey to India, two of the Fragile Five economies that are viewed as most at risk, suggest that it will be a bumpy course for monetary policy to get back to normal, after five years of extraordinary cash injections and 0% rates.
Since last May, I have written about the Great Reversal and how money leaving emerging economies had been triggers for crises before. There was a period of calm after a tumultuous summer but emerging economies are again battling to keep money flowing in.
Scale of the challenge
Turkey held an emergency meeting and raised its benchmark interest rate (one-week repo rate) to 10% from 4.5%. Yes, that's more than double, and there were similar hikes to its lending and borrowing rates that brought them all into double-digit territory. India also raised its key rate to 8% earlier in the week, and South Africa just unexpectedly hiked rates to 5.5%.
Raising interest rates aim to attract money to increasing the return to investors and it props up the currency since more investment increases the demand for the currency. For the Turkish lira that had recently hit record lows, the central bank's actions boosted it straightaway but the currency has fallen again within a day, underscoring the scale of the challenge.
The World Bank estimates that 10% of capital equal to 0.6% of the GDP of developing countries could stop flowing into those countries with Fed taper. The figure could rise to a staggering 80% if there is severe market dislocation.
With emerging economies' currencies down between 10-20% since May and continuing to decline in January after December's taper announcement, the movement of capital is evident.
The situation also gets trickier for these economies since a weaker currency means that imports are more expensive, which doesn't help inflation in places like India where CPI is about 10%, the highest in Asia.
When I spoke to a small businesswoman in Jakarta who imports parts for her factory, she was concerned about the value of the Indonesian rupiah since it would increase her costs.
Indonesia, along with Brazil which is yet to be mentioned, and the other countries that I've discussed (Turkey, India, South Africa) have been dubbed the Fragile Five for having worryingly large current account deficits which relies on money flowing in to finance.
And a weaker currency makes it more expensive to finance the widest measure of the trade deficit plus investment flows, which is why there have been rate hikes that hurt growth but are intended to stabilise the short-term macroeconomy.
So, coming back to the Fed meeting today.
The Fed's mandate doesn't extend to its global impact and though they are likely to be mindful of it, the focus of Bernanke in his last meeting will be to manage the "exit strategy" from unconventional monetary policy of quantitative easing or QE.
The Fed is expected to announce a steady withdrawal of cash injections which could mean another trimming by $10bn of the current $75bn, which is down $10bn from the original $85bn. At this pace, in the course of the Fed's eight meetings this year, the Fed will have exited QE by 2015.
The Fed faces a further challenge, which is to manage expectations that rates will rise. After all, unemployment has fallen to 6.7% which is close to 6.5%, the threshold that they set for themselves under "forward guidance" to hit before considering raising rates.
Convincing markets that as the recovery picks up, borrowing costs should stay low will be the challenge. After all, as the US economy recovers, demand will rise and so will prices. For lenders, they will want to ensure that they have a return after inflation.
This is why borrowing costs have been inching up as seen in the yield on 10-year Treasuries, now at around 2.7%, which is closer to 3%, versus being below 2% a year ago. But, if rates go up too quickly, then the recovery could be choked off.
This is why although the Fed taper has significant global implications, interest rates may be more important moving forward. It's not just for the US economy, where unemployment is still far from the 5% that it usually falls back to rather quickly after a recession, that it isn't happening this time.
But it's also because the US interest rate is the benchmark for global markets. If the US interest rate rises, then emerging markets aiming to attract money into their borders will need to raise rates even more to attract capital.
Investors may be happy with a 3% return and minimal inflation in the US and need a greater interest rate differential or return to take the risk of putting funds into an emerging economy.
It's not just economic risk, but also political risk in places like Turkey as well as upcoming elections in the rest of the Fragile Five. Or a much wider set of issues when it comes to Argentina.
The Fed will focus on setting out a course to "exit" today. But, for many in the US worried about their mortgages and business loans, as well as the rest of the world looking to attract capital, the price of money - the interest rate - will be the key to watch.