Concern has been growing about the impact the US Federal Reserve’s reduction in the scale of its bond-purchasing programme will have on emerging markets.
With the world’s largest economy showing something of a recovery of late, its central bank is starting to dial back its longstanding ‘quantitative easing’ programme of flooding new money into the economy.
This reduction in the creation of vast quantities of new dollars is expected to make the currency more attractive to foreign exchange speculators, who are therefore more likely to buy in and boost its value relative to other currencies.
For investors, this has raised the spectre of past crises in emerging markets that were caused by greenback strengthening. Mexico’s ‘tequila crisis’ of 1994 and the Asian crisis of 1997 and 1998 are cases in point.
“With the Fed finally removing its stimulus, another period of dollar strength is entirely plausible and possible,” said Stewart Robertson, economist at Aviva Investors.
There are reasons for believing that the emerging markets are better placed to withstand a dollar resurgence this time, including the expansion of local currency government bond markets – where non-US economies issue bonds in their own currencies.
But Mr Robertson insists several emerging markets will be under pressure.
He highlights India, Indonesia, Brazil, Turkey and South Africa, a group dubbed ‘the fragile five’ by economists. They are also known as the ‘twin deficit countries’ for having budget and current account deficits.
In contrast, South Korea does not have those fundamental imbalances and is among the less vulnerable, said Mr Robertson.
Emerging market bonds were boosted in the past few years by a wave of new interest from global investors, seeking better levels of bond income than those being paid in western markets where interest rates have been at all-time lows.
This influx of foreign cash pushed yields on emerging market debt down, meaning prices of bonds rose, and caused the emerging economies’ currencies to strengthen against the dollar. Much of this foreign capital was used for capital investment projects in emerging markets, explains David Lebovitz, global market strategist with JPMorgan Asset Management.
US Fed chairman Ben Bernanke’s allusion last April to the fact that US interest rates would be heading higher on the back of improved economic growth prompted an exodus of foreign money from the emerging markets back to safer investments, such as US treasuries.
This meant the source of foreign funding for these massive investment projects was no longer there, Mr Lebovitz says.
“Broadly speaking, these emerging markets need to figure out how to organically finance growth going forward; they can’t be reliant on cheap money courtesy of the major developed market central banks, because as we can see that time is slowly getting away from us,” Mr Lebovitz asserts.
Gautam Chadda, director of investment consulting at RBC Wealth Management, agrees the emerging markets with twin deficits may come under pressure this year as the dollar appreciates and as the reduction of bond purchases by the Fed gains momentum.
