Emerging markets and the Fed: what will matter for the next "tapering"?

Recent announcements and speculation about initial steps by the U.S. Federal Reserve to normalize its ultra-loose monetary policy have reminded investors in developing and emerging markets of the "taper tantrum" of 2013. At the time Fed President Ben Bernanke triggered rising yields in the U.S. and capital outflows from some developing countries with a hint about wanting to reduce the pace of the Fed's bond purchases.¹  In particular countries with large current account deficits and a large share of US dollar-denominated debt suffered with the announcement. In early 2020, when the Covid-19 pandemic broke out, EMs experienced once more a period of strong capital outflows. This time, the Fed did not trigger the capital outflows but helped to stabilize international financial markets by offering dollar-denominated credit (e.g., through swap-lines). Should the prospect of a less expansionary Fed policy trigger a new withdrawal from EMs, not only macroeconomic vulnerabilities but also the quality of policy and institutional structures will be relevant.

2013 and 2020: Macroeconomic vulnerabilities   

During episodes of strong capital outflows or capital inflow reversals, countries with a high dependence on international capital are particularly vulnerable. This dependence is particularly visible in the current account balances. A country has a current account deficit if it imports more goods and services than it exports. Because aggregate purchases from abroad cannot be financed with export revenues, foreign capital inflows must fill this gap. A rapid decline in international capital flows, as in the 2013 taper tantrum or the 2020 outbreak of the Coronavirus pandemic, forces current account deficits to narrow. Consumption and investment fall. The higher the current account deficit, the more sensitive a country is to movements in international capital markets.

Because a drying up of foreign capital leads to a depreciations of the national currencies, countries with a high share of debt denominated in U.S. dollars are particularly vulnerable. With a sharp depreciation, debt in terms of the domestic currency increases and so does debt service. The scope for other government spending falls. Both the 2013 taper tantrum and the 2020 capital outflows saw depreciations of over 20% within a few months (Duarte 2020).

By the end of 2012, among the six largest EMs - Brazil, Russia, India, China, South Africa and Turkey (BRICS + Turkey) - China and Russia were the only ones without current account deficits (Fig. 1). At the end of 2019, just before the outbreak of the coronavirus pandemic, India, South Africa, and Brazil had current account deficits once more but smaller than at the end of 2012. Turkey had already experienced large capital outflows in 2018, forcing a current account adjustment at the end of 2019. By the end of 2020, India and South Africa were running surpluses on their current accounts, while Turkey ran deficits again, mainly due to the loss of key exports (such as tourism services) and a credit-driven economic boost. Because China and Russia are net exporters and China limits capital mobility, their current account balances do not indicate macroeconomic vulnerabilities.

A similar picture holds when looking at debt denominated in foreign currency. Only in India was the debt as a percentage of GDP lower in 2020 than in 2012 (Fig. 2). In Turkey, in contrast, it rose to almost 60% of GDP in 2020. In second and third place were Brazil and South Africa. In the wake of the Coronavirus pandemic GDP fell, and fresh debt was raised. A further depreciation of the currencies may bring highly indebted countries into payment difficulties.

2021: Political structure and political instability

Looking only at the macroeconomic criteria, Turkey and Brazil would be particularly vulnerable to renewed capital outflows. But after more than a year of crisis management, the countries' political and institutional frameworks will likely be particularly important to investors. The covid-19 pandemic hit several developing and emerging economies previously dealing with a combination of poverty, overwhelmed health systems, and political discontent. Already in 2019, citizens of numerous countries went to the streets against their governments. The coronavirus pandemic temporarily blurred the focus of the protests and, in the background, amplified the very issues that motivated the protests in the first place: poverty, perceived injustices, and corruption.

Decreasing prosperity contributes to political instability. The World Bank estimates that by 2020, the number of people below the poverty line could have risen by 88 million. The hardest hit are developing countries, whose government systems can hardly compensate for the welfare losses. Increasing poverty in one country motivates emigration to richer countries. Because travel restrictions were considered one of the most important tools to curb infections, and because richer countries protected their welfare states with migration barriers, this way out was unlikely. With rising unemployment, low vaccination coverage, and recurrent lockdowns, more people worked in the informal sector without legal protection. This unequal treatment fueled perceptions of social injustice and brought more discontent against the existing political system. This is particularly true in Brazil, South Africa, and India, where poverty and social inequality are highest among the 6 largest EMs.

Authoritarian political power and corruption are also a risk for international investors. The countries considered above are ruled by presidents who have a great deal of decision-making power without democratic control. The extreme case is China, where recent interventions against the country's largest technology companies reflected the steering power of the government. In Turkey, President Erdogan replaced the central bank governor three times because none implemented his more than questionable ideas on monetary policy. In India, two central bank governors ended their mandates prematurely and later expressed concerns about the pressure the executive exerted on central bank decisions.  In Brazil and South Africa, not only dysfunctional governments but also corruption scandals are causing political turmoil. On the corruption perception index, Russia scores the worst with 30 (Fig. 3, higher scores mean a less corrupt government). The other countries fluctuate around an index value of 40, half that of Germany. The additional financial resources raised for pandemic management are likely to have further fueled corruption, making further political discontent from corruption scandals over pandemic aid and the procurement of masks, vaccines, etc., not surprising.

With a new episode of capital outflows, investors are likely to look not only at traditional macroeconomic vulnerabilities, but also at the fragility of countries' political and institutional structures. The further to the left the countries are in figure 4, the higher their current account deficits, and the further down they are, the worse they score on the corruption index. The BRICS+T countries perform comparably bad on the corruption index, while Brazil and Turkey are most vulnerable on the macroeconomic side. Other countries showing vulnerabilities in both indicators are Colombia, Romania and Egypt.

Things are changing fast. The Corona pandemic continues, and vaccination rates are still low. A new episode of capital outflows could significantly worsen the economic and social situation in more countries. As with corporations, countries with robust finances and good "governance" structures will better weather a tightening of monetary policy in the US.

References

Duarte, Pablo, Emerging Markets under Corona Pressure, Flossbach von Storch Research Institute, Kommentar 13.08.2020

¹ „Although the Committee left the pace of purchases unchanged at today’s meeting, it has stated that it may vary the pace of purchases as economic conditions evolve.  Any such change would reflect the incoming data and their implications for the outlook, as well as the cumulative progress made toward the Committee’s objectives since the program began in September.   […]  If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.  And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.” Bernanke, Pressekonferenz am 19. Juni, 2013.

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