Emerging market crisis may derail global economic recovery

The emerging market (EM) crisis currently underway in Asia and Latin America may derail the incipient global economic recovery, according to the weekly analysis released by QNB Group on Saturday.   The financial turmoil unleashed by the Federal Reserve (Fed) announcement that it will start tapering its asset-purchasing program soon the so-called Quantitative Easing (QE) has led to large capital flight from most EM, a large weakening of their currencies, and higher long-term interest rates globally. If the Fed starts QE tapering in its forthcoming meeting on September 17-18 as announced, this is likely to unleash further EM capital flight, thus undermining their economic growth and reducing global export demand. This will inevitably have a knock-on effect on the relatively weak growth in the US and the incipient recovery in Europe, said QNB Group. Ultimately, QE tapering may well be self-defeating as it could in fact lead to lower growth both in the US and the rest of the world, thus derailing the global economic recovery according to QNB Group. On June 19, Fed Chairman Ben Bernanke announced a tapering of its QE policies contingent upon continued positive US economic data. This announcement marked an end to three waves of QE that have flooded US financial markets since 2009 with an estimated USD2.9trn (19.3% of US GDP), according to the economic research of the Federal Reserve Bank of St. Louis. The opportunities, however, to invest these resources have been limited in advanced economies given near-zero interest rates in Europe, Japan, and the US. Global financial institutions therefore used a significant portion of this liquidity to invest in EM, which offered higher returns. This led to higher EM exchange rates, lower interest rates, and to some extent higher growth momentum. Unfortunately, the QE party for EM came to an end on June 19. As has been the case in previous EM crises, it pays to be the first one out of the door, because exchange rates are still high and it is easier to liquidate large financial investments when foreign exchange liquidity is still plentiful. Accordingly, global financial institutions have rushed to liquidate their EM investments since the Fed announcement in order to cash in their capital gains and avoid being faced with policy measures that could restrict their capital movement. The result has been a panic selling of EM exchange rates (Figure 1). The Fed announcement has also lowered demand for government bonds globally, thus leading to higher long-term interest rates in EM and, to a lesser extent, in advanced economies. This has shaken EM consumer and investor confidence, which will inevitably lead to lower economic growth going forward.  EM Central banks have added to the capital flight by trying to lean against the wind. They have used their international reserves and raised policy rates to defend their currencies. Most prominent in this defense has been the Reserve Bank of India (RBI), which has witnessed a decline in the Rupee of 14% since June 19. In response, the RBI has used its international reserves to defend the Rupee and tightened liquidity. Restrictions on gold imports and capital account outflows have also been tightened in order to stem the outflow without success. At the same time, there are early signs that the Indian economy is slowing down rapidly, with the HSBC Purchasing Managers Index indicating the manufacturing sector contracted in August for the first time since the global economic crisis of 2009. There is even talk of a possible IMF credit line to help India weather the storm. Similar narratives are occurring in other EM, like Brazil, Indonesia and, to a lesser extent, Malaysia and Thailand. Overall, the EM crisis resembles in many aspects the Asia crisis of the late 1990s. Today’s EM crisis has serious implications also for advanced economies. Unlike in the 1990s, advanced economies are today more than ever dependent on EM for their own growth. China, the US, Germany and Japan were the world’s largest exporters in 2012 and an increasing share of their exports have flown to emerging markets in recent years. A significant decline in EM growth would inevitably have a knock-on effect on their own exports and therefore on their growth momentum. This comes at a critical time in the global recovery, where the United States is still showing relatively weak economic growth and Europe is slowly coming out of a two-year long recession. A significant slowdown in EM economic growth could therefore put in jeopardy the recovery in advanced economies as well. Overall, all indicators show that QE tapering may, at this stage, have negative implications for both EM and advanced economies. During the Jackson-Hole meeting in late August, Fed officials have ruled out taking a global perspective into account in formulating their QE tapering. According to the QNB Group, if the Fed does taper now, this will worsen the EM crisis and may derail the global economic recovery, including in the US.