Fed Quantitative Easing and Emerging Market Currency Weakness

Just a few weeks ago, when some emerging market currencies came under renewed strong pressure and the central bank of Argentina suspended to intervene in the foreign exchange market and the central banks of India and Turkey hiked their key interest rates, many commentators compared the situation with the Asian currency crisis in the late 1990^th. However, in-between, the situation has calmed down a bit and the US stock market posted the first week with a gain in this year. From our point of view, the situation is not comparable to the Asian crisis.

There are several indicators, which could lead to a currency crisis, especially when a country has a fixed exchange rate regime. The first factor is increasing indebtedness in foreign currencies. Often, the interest rate level in an emerging market country is higher than the one in a country, whose currency is regarded as a reserve currency. Thus, it is not surprising, that borrowers try to take advantage of the interest rate spread between two currencies. The amount of outstanding borrowing in foreign currencies increases. Sooner or later, foreign exchange analysts regard the level of foreign debt as unsustainable and write reports with the recommendation to sell this currency. As traders and investors follow those recommendations, the currency weakens and the cost of servicing the debt in a foreign currency increases. These costs are then regarded as unsustainable in foreign exchange markets and the pressure on the currency intensifies.

However, statistics about the debt in a foreign country only state the amount of debt but not whether this debt is hedged against currency fluctuations or fully exposed to the exchange rate risk. Private entities as well as governments could enter swap agreements that transfer the foreign currency loan into one denominated in the domestic currency. The disadvantage of those swaps is the reduction in the borrowing costs is given up to a large extend.

Some central governments from emerging market countries, like for example Turkey, are frequent borrowers in international bond markets. If not explicitly ruled out by law, those governments could reduce the foreign exchange rate risk without sacrificing a large part of the interest rate advantage of borrowing in a foreign currency. They could enter an agreement with the central bank to sell the proceeds from the bond to the central bank for obtaining the corresponding amount in local currency and at the same time agree to reverse this transaction when the bond is due. The central bank would have an increase in foreign reserves and could invest this increase in a bond which expires shortly before the bond of the central government is due. Thus, the central bank would have the necessary liquidity back when the reverse currency swap with the government would be due. In addition, the central bank could earn interest on the bond in foreign currency. As the profit of central banks is usually distributed to the central government, the foreign exchange rate risk would be widely reduced. By and large, only the spread between the interest rate paid by the government on its bond and the interest rate earned by the central bank would be exposed to the risk of exchange rate fluctuations.

Such a transaction would not only reduce the exchange rate risk for the central government, but would also sterilize the impact of government borrowing on the current account. The rise in capital imports is neutralized by the increase of foreign reserves. However, the central bank extends its balance sheet. But also this effect could be sterilized by withdrawing liquidity from the banking sector.

Another indicator often quoted is the rise of capital imports. An increase of capital imports is viewed as a growing dependence on foreign capital inflows. Furthermore, it is argued that those capital imports would increase the debt of the private and government sector in foreign currencies, and thus, would intensify the risk of an unsustainable debt level if the currency depreciates. This could indeed be the case. However, also in this case, a more in-depth analysis is required for avoiding the wrong conclusions. Capital imports are not necessarily the result that a country would have to obtain funds in a foreign currency to finance its imports. The rise of capital imports could also be the result of foreign investors, seeking higher returns, increase their investments in assets of an emerging market country. Investments in equity markets or bonds issued at the domestic primary market are normally denominated in the local currency. In this case, the investor would have to bear the foreign exchange rate risk. The higher capital imports in this scenario do not alter the level of indebtedness in other currencies, and thus, they do not change the risk that exchange rate fluctuations could lead to a default of private or public debtors.

The third indicator for the risk of a currency crisis is the development of the current account. A rising deficit in the current account is regarded as unsustainable if a certain ratio of current account deficit to GDP is exceeded. However, a closer analysis of the factors driving the higher deficit is also needed for this indicator. If, as it is often the case, the widening current account deficit is due to an increased demand for foreign goods and services by the emerging market economy, then this indicator could rightly point to an increased risk of a currency crisis. But if the original impulse comes from foreign investors purchasing more assets of an emerging market economy, then the situation is different. Even if the central bank tries to neutralize the impact of higher capital imports induced by the demand of foreign investors, it normally cannot fully sterilize the impact of foreign investors on the balance of payment. Thus, if capital transactions induced by foreign investors are the main reason that the capital account shows an increased net-import balance, then the current account has to be in a deficit. This is an underlying condition of balance of payment accounting.

The Economist published an interesting chart some weeks ago, which displayed the cumulative purchases of bonds and equities of emerging market economies by institutional investors. The striking point was, that the cumulative purchases started to increase already at the beginning of the new millennium, thus, about one decade before the Fed implemented quantitative easing. The glut of capital flows from two Asian countries with huge current account surpluses into Western capital markets depressed the return on government bonds, especially on US Treasury notes and German Bunds. However, also the spreads of other Eurozone member countries over the benchmark bunds fell considerably. Thus, institutional investors sought to achieve higher returns to meet expectations of funds sponsors by investing in emerging markets.

The financial crisis only shortly led to a decline of the cumulative investments in emerging market equities and bonds. For bonds, they almost fell back to zero. However, already in 2009, the cumulative investments reversed direction again and increased strongly due to the massive stimulus measures taken by China. The quantitative easing measures of the Fed supported this move, but were not the trigger. Therefore, the rise of capital imports by emerging market economies was induced by the decision of investors to allocate more funds for the purchase of emerging market stocks and bonds. By mid-2013 the level of cumulative investments in emerging market stocks as well as in bonds exceeded the pre-financial crisis amount by far. As lined out above, those investors also had to bear the risk of exchange rate fluctuations.

As former Fed chairman Bernanke announced in May at a Congress testimony that the FOMC might decide to taper at one of the next few meetings, institutional investors and fx-traders came to the conclusion that less money would flow into emerging market assets. In addition, rising yields on US Treasury paper had to be expected and the yield on the benchmark 10yr US T-Note indeed rose to 3%. Thus, also the relative advantage of domestic emerging market bonds changed. In this altered environment, institutional investors had to adjust their asset allocations. As a result, they reduced exposure to emerging markets, which already led to currency weakness in the summer of 2013. With the start of tapering in January, another wave of currency weakness set in.

However, as it were institutional investors, which increased their exposure to emerging markets, they were also the driving force behind the rise of capital imports and current account deficits by emerging market countries. They invested in assets denominated in local currencies of the various emerging market economies. The repatriation of funds could have a positive impact on the emerging market countries. With the devaluation of their currencies, their products gain in international competitiveness. The capital account should no longer be the driving force for the current account, which should improve. Thus, the situation is different than it was in the late 1990^th at the Asian currency crisis. That the situation has calmed down might be due that more investors recognized the differences.