Who’s to blame? The Fed taper debate and contagion

US dollar notes Image copyright AFP

Are the woes of emerging economies due to the Fed taper - the US central bank winding down its cash stimulus programme?

Or is the looming end of the era of cheap cash simply exposing the underlying structural problems of emerging economies?

In the latest edition of Talking Business, the panellists largely didn't think that there was much the Fed could do about it, while the Indian central banker Raghuram Rajan has been calling for greater global cooperation.

Of course, they're not mutually exclusive positions.

Even if the Fed didn't cause the economic structural challenges often associated with developing countries, it can still pay heed to the global consequences of its actions.

Since the global financial crisis, emerging economies have seen around $4 trillion (£2.4tn) of capital coming across their borders.

Some of it was investors seeking a better return in faster growing markets while developed economies suffered recessions. But, as the US in particular recovers and the Fed starts to wind down its cash injections, the world's biggest economy becomes more attractive.

The World Bank estimates that half of the capital that has been flowing into emerging economies could stop.

This "sudden stop" of cash can be destabilising.

Lessons from history

A look back at previous currency and financial crises gives a sense as to why.

What economists call the first generation currency crisis refers to the Latin America crisis of 1981-82.

Countries such as Brazil, Mexico, Argentina and Chile had three traits that made them vulnerable to a "sudden stop" of cash inflows: large fiscal deficit, large current account deficit and inflation.

In other words, each of these traits put pressure on their fixed exchange rate against the US dollar, known as the Tablitas.

These "twin deficits" (budget and trade) and high inflation are why some emerging economies are being viewed as vulnerable.

But, one difference is that emerging economies are no longer as wedded to maintaining currency pegs, so it makes it somewhat harder for speculators to attack the currencies.

Instead, the problem now is that some investors are pulling out and that's causing these economies to raise rates to try and keep in the foreign money to which their businesses have grown accustomed.

It's the reason the Turkish central bank raised its overnight lending rate to 12% from 7.75% after an emergency meeting last week, and also for the rate hikes in India and South Africa.

This was also a feature of the second generation currency crisis that refers to the collapse of the European exchange rate mechanism (ERM) in 1992.

Britons may recall Black Wednesday when Sterling and other currencies such as the Italian lira left the peg to the Deutsche Mark that they signed up to two years earlier when it became too costly to keep their currencies pegged.

In the UK, to keep attracting capital, interest rates rose from 10% to 12% and eventually 15%.

It became too costly in terms of economic growth (Britain was raising rates during a recession) and thus the UK and others left the ERM.


I've written about the third generation currency and financial crisis before.

What distinguishes this from the first two is that the 1997-98 Asian financial crisis was a financial crisis that led to a currency crisis.

When Thailand saw foreign money leave, it led to the Thai baht collapsing. It is similar in that sense to the current concerns over emerging economies.

When the money leaves, will these economies be able to cope with a weakening currency that makes it harder to service large external debt positions and makes imports more expensive which leads to inflation?

This is why you hear these countries talk about how much they have in foreign exchange reserves so that they can finance their current account deficits and in some cases like Brazil, directly intervene in their currencies.

The other worrying trait of the third generation crises was contagion.

Although Asia is linked via trade and investment, the impact of the Asian financial crisis was widely felt throughout emerging economies, spreading to Russia in 1998, Turkey in 1999, and Brazil and Argentina by the early 2000s.

Argentina then defaulted - that is still being untangled.

These economies didn't trade or invest a great deal with Thailand, Malaysia, etc. But, emerging economies tend to be invested in as a single class, so when investors pull out, then they tend to leave the class.

There's some evidence of it happening as investors have moved money out of what are called emerging market ETFs (exchange traded funds). Emerging economies now will want to be judged more discriminately and that may allow contagion to be avoided.

Current turmoil

Coming back to whether the cause of this global market turmoil is the Fed's loose money regime.

They injected cash to cope with the 2007-08 crash, which of course then set the global conditions that brought us to where we are now.

Investors went and sought better returns, including in emerging economies especially as the large ones such as China, India, Indonesia were largely spared the fallout from the US sub-prime crisis.

The Fed's move to end quantitative easing after 5 years isn't a surprise.

But, how smoothly it unwinds the cash injections and the pace at which it is done will impact emerging economies.

It may not be the determining factor in terms of whether a country faces a crisis, of course. For those countries that now face the prospect of money leaving their borders, whether they have wisely managed the cash in terms of regulating the indebtedness of their companies will be telling in how well they cope with the end of the era of cheap cash.

As global markets are inter-linked, how emerging economies cope will reverberate back to the US.

Perhaps the answer to who's to blame is that causation is difficult when there are numerous macroeconomic linkages so there isn't one cause but rather one action leads to another.

As a statistics teacher would say, correlation doesn't imply causation. It may be that it's not a question of who's to blame, but rather how to disentangle and manage the many correlations in an interconnected world economy.

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