Blog | Personal Finance

Emerging Market Convulsions

Emerging Markets went into convulsions last week as foreign capital headed for the exits. Equities and currencies took a significant hit in most of the developing economies around the world. This near panic was set off by growing concerns about the Federal Reserve’s plans to reduce Quantitative Easing (QE) in the United States.

Argentina was the hardest hit. The Argentine peso fell 20% in January (and 15% in just one day). Brazil, India, Indonesia, Hungry, Russia, South Africa, and Turkey were also affected.

So, here’s what happened. Most of the countries impacted import more than they export. Therefore, they must attract foreign capital to finance their trade deficits (much like a family that spends more than it earns must borrow money to finance that gap). Most of the time, it is easy for the Emerging Markets to attract plenty of foreign capital. Foreign investors are generally keen to invest in the Emerging Markets to profit from the higher interest rates and the faster rates of economic growth those economies tend to offer. After the global economic crisis began in 2008, the flow of capital into the Emerging Markets accelerated for two reasons. First, as interest rates fell to historic low levels in the developed economies, the higher interest rates on offer in the Emerging Markets became increasingly attractive. The second reason is that the Fed and the central banks of Japan, England and the Euro Zone created trillions of dollars worth of new fiat money. A significant amount of that new money found its way into the Emerging Markets.

Then what went wrong? The thing that changed is that the Fed has announced that it intends to gradually reduce the amount of money it creates each month and to end its program of Quantitative Easing (i.e. money printing) altogether before the end of 2014. Last year, the Fed created $85 billion every month. In January, that was reduced to $75 billion and in February the amount will be reduced again to $65 billion.

While $65 billion is still an enormous amount of money to be created in only one month, investors are looking further ahead. They sense that money will become tight later this year if the Fed continues to taper QE, as it has signaled that it will. They understand that tighter financial conditions will damage the growth prospects of the Emerging Market economies and cause asset prices there to fall. Therefore, foreign investors are taking their money out now rather than waiting around to be the last to leave the party.

So, even though there is a great deal of excess liquidity in the developed economies, and even though the Fed is expected to add $65 billion more to that pool of excess liquidity in both February and March, money is fleeing the Emerging Markets; and this outflow of money is damaging the economic prospects of those countries and causing asset prices there to fall.

The outflow of capital is causing the Emerging Market currencies to depreciate. With their currencies depreciating, those countries must pay more for the goods they import; and the rising cost of imports is causing inflation to increase. Consequently, the central banks in those countries are being forced to raise interest rates to combat the rising inflation. Higher interest rates, however, will cause those economies to grow more slowly.

With foreign capital departing, there is generally little that the economic policymakers in those countries can do to prevent their economies from being hit. Many of them feel increasingly bitter about their helplessness in the face of global capital flows over which they have very little control.

What, then, should Emerging Market investors (and the people who live in the Emerging Market countries) expect next? Unfortunately, things will probably get worse before they get better. As we have seen many times before, when the tide of global money goes out, companies and banks begin to fail. Such bankruptcies tend to exacerbate the panic, causing even more capital outflows. Panic is contagious. It tends to spread to all corners of the world before it burns itself out.

So when will this Emerging Markets selloff end? I believe it will end when the Fed announces that it will stop tapering QE. I believe the Fed will make that announcement before the middle of this year. If it does not, liquidity conditions in the United States will begin to tighten and tighter liquidity will threaten to throw the US back into recession. If I am right, QE will not end in 2014. Instead, the Fed will end up creating another $500 billion to $1 trillion in 2015.

If this scenario unfolds as outlined above, then foreign investors will turn keen on the Emerging Markets again by mid-year when the Fed signals it will extend QE. At that point, they will send a new flood of liquidity gushing back into the developing world. If so, asset prices there will once again surge.

To me, this seems the most probable scenario. Unfortunately, a lot of damage may be inflicted on those economies (and on those who invest in those markets) between now and then.