What Emerging Markets Tell Us About Quantitative Easing
The recent emerging markets crisis – one a long time coming, depending on who you ask – started on cue from Ben Bernanke that the Fed would “taper” its unprecedented injection of liquidity into international markets. That emerging markets responded so poorly tells us something important: they expect the taper to come much too soon.
In principle, the Fed wants to continue with its “expansionary” program until the United States is growing quickly again. The “Evans Rule” ensures we will keep a zero interest rate policy until unemployment has fallen below 6.5%, though no such forward guidance exists for QE.
In reality, if emerging markets expected QE to come only after the US economy was healthy again, this kind of depreciation of currency and fall of stock would be very unlikely. A robust US economy implies a growing demand for exports denominated in EM currencies: boosting both the currency and stock market. While the expectation of future growth probably wouldn’t offset entirely the effect of curtailed liquidity, it would have likely contained much of the depreciation.
Emerging markets are a more informative tool to this effect than American stocks. While we can infer the same conclusion – that tightening will be premature – from our stocks’ sensitivity to QE, US markets are too closely connected with QE’s direct wealth effect, obscuring observation of expectations.
Of course, the massive liquidity from QE also plays a direct effect on emerging market currencies, but it’s fair to guess the relative sensitivity of EM currencies is lower than that of American stocks. (For example, a good jobs report might actually freak Wall Street out, whereas emerging markets are relatively insulated from that).
This is a somewhat contrived argument, still, the magnitude of currency deterioration across Asia should somewhat revise our beliefs that tapering is coming sooner than it should.
You could also argue the reverse, that the taper indicates that the US economy is healthy, and that this means people expect opportunities for investment in the developed world to have higher returns than investments in the emerging markets. This results in a large reallocation of capital flows towards developed world to make up for the “shortfall” in capital investment over the last five years. These changes in capital flows have resulted in large changes in currencies because investment is such a large part of the GDP of EM countries compared to developed countries.
I saw today, for example, that corporate investment in Japan has risen 4% quarter on quarter. If this story makes sense the change in capital flows should come with large increases in US corporate investment, and corresponding decreases in EM investment.