Opinion: Emerging Markets Tremble as Monetary Policy Returns to Normal

By Andrew Sheng

The U.S. 10-year Treasury bond rate has now sharply adjusted to over 3% per annum, ending a period in which the rate was below 2% because of unconventional monetary policy.

Is this the beginning of the end of the post-2007 global financial crisis abnormal pricing of market interest rates and risks?

Furthermore, has the financial markets priced in the risks of deflation of the asset bubbles across almost all markets, especially emerging markets?

Perhaps I am wrong, but the present markets feel eerily like 1996 and 2006, when everything in the real economy and financial markets appeared to be going well, but the next year, the Asian Financial Crisis and the Global Financial Crisis broke the markets with a vengeance. To recap, growth in both 1996 and 2006 looked strong, and financial institutions reported good profits, with only some worries that some market players were perhaps a tad overstretched.

In late 2017, the International Monetary Fund (IMF) predicted that there was a synchronized recovery across all economies, with even Europe recovering, but in this year’s April Spring Meetings, the IMF was already signaling that recovery may be sputtering, especially in Europe. Furthermore, there is some serious concern that the outbreak of the U.S.-China trade war will have collateral damage on Europe and Japan, as the added costs on aluminum and steel would raise costs for European and Japanese car and machinery exports.

As all indicators seem to suggest that the U.S. economy is already beginning to operate at full capacity, with growth back to the normal range of 2-3% and inflation back up to just under 3 % with the lowest unemployment rate recorded, the U.S. Federal Reserve is already signaling that interest rate normalization and withdrawal of quantitative easing through shrinkage of its balance sheet should be on the way. Unlike the last time when the Fed signaled higher rates, the advanced financial markets did not throw a tantrum.

But in the emerging markets, things are now beginning to get ugly. First, Argentinian interest rates rose to over 40% to defend the stability of the peso. Argentina was forced to call in the IMF to give some moral support and advice. Lately, outflows from emerging markets seemed to have accelerated, as the Turkey lira got into trouble in the run up to the elections, and even Indonesia had to raise interest rates to keep the rupiah from depreciating too much against the dollar.

The Turkish situation is quite problematic, because the current geopolitical situation is that Turkish relations with the Europe is strained and the U.S. no longer considers Turkey an indispensable ally in the Middle East. In the meantime, the complex Middle East situation, whereby the oil producers are also under deep fiscal strain means that the surplus economies may not be willing to help Turkey in this tough spot.

What we are now witnessing is the cyclical return of “normalization” of interest rates and risk spreads, even as central banks struggle to withdraw their unconventional monetary policy. The basic story is as follows.

In the dollar-dominated world, the U.S. dollar is the benchmark currency for pricing of exchange rate, interest rate and credit risk spreads. As the Bank for International Settlements warned last year, with $10 trillion in U.S. dollar credit outstanding outside the United States, much of which is issued by emerging market corporations, an appreciation of the U.S. dollar would have a deflationary impact on corporate balance sheets, as their income is often in local currencies.

When the corporations and government U.S. dollar debts have to pay their U.S debts, their principal source of foreign exchange is the sales of their local currency in exchange for dollars, mostly obtained from their local central banks. Central banks that face an outflow of capital in U.S. dollars have the choice of either losing reserves or raising interest rates to keep a stable exchange rate.

Those who choose to defend by raising interest rates will then also face slower domestic growth and deflation in their domestic asset markets. There are no easy choices in this situation.

As foreign investors realize that emerging market economies are under pressure due to the stronger dollar, then they will demand a higher credit spread over U.S. treasury interest rates to compensate them for both credit and foreign exchange risks. This means in effect that the credit spreads will widen, so that the local currency (and foreign currency) yield curve of a particular emerging market will steepen against the U.S. dollar yield curve faster and higher than the potential rise in the U.S. interest rate. In other words, the domestic interest rate will rise not in a linear relationship, but exponentially, which explains why Argentina interest rates rose to 40 % per annum and Turkish lira interest rate is in the high teens. Foreign and local investors anticipate either a devaluation or sharp slowdown and want higher interest rates to compensate for the potential loss.

We should also ask why the U.S. long bond rate is also rising higher than short-term rates. This is partly due to the fact that the surplus economies have shifted from China and emerging markets (such as oil producers) to Europe. The European Central Bank recycles its surpluses not into dollar reserves, which would keep the U.S. long-bond rate low, but into deficit economies within the eurozone. Hence, the U.S. long bond investors no longer have the luxury of continuous buying by Chinese and emerging market central banks to get higher yield. The basic global saving-borrowing balance is now tilted toward normalization of U.S. interest rates.

All this means that emerging markets are now faced with prospects of higher domestic interest rates and tougher management of deflation of domestic asset bubbles, caused by a long period of unprecedented and low global interest rates.

This makes the management of domestic financial stability tougher, because the real economy is now been stressed by technological disruption as the business model of cheap labor exports has gone with rising protectionism and robotic manufacturing, reducing the need for consumer imports.

To sum up, we will witness going forward a re-pricing of global credit and liquidity risks as the dollar threatens to rise in value during geopolitically tense times. Look out for more turbulent emerging market stresses.

Andrew Sheng is a distinguished fellow at the Asia Global Institute, University of Hong Kong.

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