QE3 and Emerging Market Currency Weakness

A few years ago, when the Fed embarked on quantitative easing and decided to extend its balance sheet, the finance minister of Brazil, Guido Mantega, coined the term currency war. However, he was not alone in its criticism of unconventional monetary policy by the US central bank. Also finance ministers of other emerging market economies and even the German finance minister joint the chorus of complaints. Quantitative easing would be targeted to weaken the US dollar in order to gain an unfair competitive advantage for US exports.

In this blog, we pointed out that quantitative easing by the Fed would facilitate shifting funds into emerging market economies, but would not be a necessary condition. Furthermore, we argued, that expected returns would play the main role in international asset allocations and capital flows. Indeed, as the chart below shows, some currencies strengthened against the US dollar after the implementation of QE1, but did not firm beyond levels already reached in 2008.

After Fed chairman Bernanke announced at a Congress hearing in May that the FOMC might decide to taper the bond purchasing program at one of the next council meetings, Mr. Mantega and his colleagues criticize the measure again and demand that the FOMC should consider more the impact its measures will have on other economies. Normally, one would expect that those emerging market economies, which suffered under the capital inflows and a stronger currency against the US dollar should now be glad that the Fed considers to take away the punch bowl, which they blamed for the developments in 2010 and 2011. But the opposite is the case.

Since the statement by Mr. Bernanke at the May Congress hearing, the weakness of the Brazilian real, the Indian rupee and the Turkish lira accelerated. However, these currencies already weakened before the Fed prepared the markets that QE3 would not last forever. But these currencies depreciated already earlier.

Hedge funds following a global macro strategy can and often do destabilize emerging market economies. At the first stage, the look for earning perspectives. Brazil and India looked attractive as being part of the BIRC group. In the case of Brazil, also the commodity demand of China made investments in Brazil appealing.

But at this first stage, hedge funds and other financial investors ignore the impact of their investments on the current accounts of the emerging market economies. If the capital inflows are massive, they lead to a stronger currency and a worsening of the current account balance. However, eventually the current account deterioration leads to capital being withdrawn from emerging markets. Initially, Brazil profited from rising commodity prices due to the brisk recovery of the Chinese economy.

In a recent article, Barry Eichengreen, pointed out that the policy of the Peoples’ Bank of China to cool down Chinese GDP growth had a negative impact on those emerging economies, which currencies came under stronger pressure recently. We agree with this conclusion. However, we also underline that for the Chinese export driven economy, the austerity policy in the Eurozone, which lead to a double recession there, also contributed to the decline of the GDP growth rate from 12% down to 7%. This had a negative impact on other emerging market economies by a negative price and volume effect. Mr. Eichengreen is also right in highlighting that domestic policy failures also are an important factor that some emerging economies now suffer under stronger currency weakness while other don’t.

However, also the central banks, at least in India and Brazil also contributed to the reversal of capital flows. At the time the Fed started to implement QE1, both central banks increased their key interest rate as the chart above shows. But increasing interest rates have a negative impact on real economic activity sooner or later and thus, they reduce the incentive to invest in the economy. Hedge funds then not only liquidate investments in the stock markets but also start to speculate on a weaker economy and/or that the central bank policy would not be sustainable and short the domestic currency against the US dollar or other currencies.

A currency weakness should lead to an increase in competitiveness and an improvement of the current account. However, this effect could be expected only in the medium-term. In the short-run, the weaker currency implies higher import prices, which leads to a further widening of the current account deficit. This effect is well known in economic theory as the J-curve effect.

The worsening of the current account balance is for precious metals markets relevant in the case of India, which is a top consumer of gold, together with China. The Reserve Bank of India (RBoI), has reduced the key repurchase rate already in 2012 and took several more steps in this year. It is less likely that the RBoI will increase its key interest rate again. However, the RBoI also took measures to curb the import of gold, the main item contributing to the current account deficit. Thus, a further weakening of the Indian rupee could lead to more restrictive measures to reduce the import of gold into India. Gold investors should not be surprised is India’s physical gold demand would be weaker than expected this festival season.