The US housing market in the run up to 2007 was booming but a large part of the booming mortgage market was based on what has come to be known as Sub-prime mortgages whose popularity increased markedly through securitisation in which the risky loans were “spliced and diced” into investment packages sold to domestic and foreign investors. Consequently, these these risky financial instruments proliferated through the US economy and with the exposure of foreign investors, when the housing bubble burst mid-2007, the effects were far reaching.
One result of the housing market rupture was the collapse in asset prices and the increase in number of homes in negative equity or in foreclosure. As Americans pared back on their spending, companies responded to the slack in demand and increased cost of finance by laying off workers in droves, which further entrenched the economic slowdown and eventually tipped the economy into recession in December 2007.
Events came to a head after Lehman Brothers folded in September 2008 and as the US economy teetered at the edge of an into the abyss, the pressure on US politicians to do something meant the world witnessed unprecedented bailouts of banks, insurance firms and car manufacturers as well as a roll out of other relief programs like TARP and TALF.
Also, the US Federal Reserve, which manages the economy through target rates of inflation and unemployment, deployed an extraordinarily loose monetary policy in the form of low short-term interest rates coupled with Quantitative Easing to support the economy. Quantitative Easing (QE) involves actively injecting money into the economy through bond purchasing programs like QE1 (12/08 – 03/2010), QE2 (11/2010 – 06/2011), Operation Twist (09/2011) and QE3 (09/2012 – ). Thus for half a decade, the US economy has been actively medicated and nursed by the Fed which in the process has tripled the size of its balance sheet since 2007 – now more than $3.1 trillion.
Of recent however the markets have been fed data which reveal signals from an improved housing market, an improved employment outlook, and robust corporate results. These signals and others point to the fact that the US economy is getting back to its feet.
A patient getting better is normally good news. However in this instance, that news comes with the implication that the era of easy money is coming to an end as the Federal Reserve would begin pulling back from its bond purchases and the benign interest rates the US economy has enjoyed for half a decade would begin moving north. The Fed currently injects $85 billion into the economy through its monthly by purchases of $45 billion of Treasuries and $40 billion of mortgage bonds. While no one credibly expects the Fed’s easing to go on forever, the future taper and eventual suspension is giving many food for thought. In a recent speech, (July 31) the Fed Chairman gave no indication of when tapering would commence but there is little consensus amongst analysts as to when tapering could start – for example some expect tapering to start as soon as September 2013 while others think US GDP growth is still too fragile and expect the taper to commence much later in the year.
The Economist notes that since 2009, some 4 Trillion USD has washed up on the shores of Emerging Market economies in search of higher yields, flushed out and pushed by low rates in the developed world which have been artificially held low by various loose ‘unconventional’ monetary policies from the Fed, Bank of England, Bank of Japan and the European Central Bank.
While Barclays is cutting its growth forecast for Emerging Markets to 5% (2013) and to 5.6% in 2014, there is a realisation as captured by James Gruber in an article on Forbes, that with stocks, bonds and currencies already under-performing those in the developed economies, the “love affair” with emerging markets was “fading”. Just as party goers head home at the crack of dawn, so too it seems are Emerging Market investors as net redemptions from equity funds are rising and bond fund flows have turned negative.
Reasons for this bearish stirrings are rooted in fear that upon the Fed’s commencement of normalisation of monetary policy, the reverse flows from the emerging market or what Barry Eichengreen of Berkeley University calls a ‘tsunami of capital flows’ would lead to a collapse in asset prices, currencies and growth rates in a financial crisis reminiscent of the Asian financial crisis of 1997.
In Ernst and Young’s Attractiveness Survey Africa (2013) it is noted that Emerging Market investment in Africa has grown at a compound rate of 20.7% and it has been instrumental to Africa’s growth over the past 5 years (2007 – 2012). While the report reveals that investment in Africa by developed economies has grown less than that for EM, (8.4%), the salient fact is the intra-Africa investment, which has grown 32.5% since 2007. The growth of intra-Africa investment has been largely on the back of countries like South Africa – which, as reported by the Ernst and Young survey, is the single largest investor in FDI projects in Africa – outside South Africa.
The story of Africa’s growth in the first decade of the 21st century has been well documented for example the IMF notes that 6 of the fastest growing 10 countries in the world between 2000 and 2010 were African countries and going forward the IMF further forecasts that 11 of the 20 fastest growing economies to 2017 would be African economies. However Ebrima Faal, of the African Development Bank notes in the Ernst and Young Attractiveness Survey Africa (2013) that Africa’s growth would be hampered unless the annual infrastructure gap of 50 Billion USD is bridged. Thus, FDI is crucial to the continent – not only for infrastructure, but also for the creation of jobs as over the past decade, Ernst and Young report that FDI in Africa has been responsible for the creation of 1.5Million new jobs and many more indirectly.
It can therefore be asserted that the importance of developed market and emerging market capital inflows to Africa as well as South African intra-Africa investment cannot be underestimated. The inference here is that QE tapering or abandonment, coupled with a reversal of the the low short-term rates in the United States would not only strengthen the dollar and adversely affect these African investment flows but also induce weakness in commodity prices – another pillar on which the African GDP growth rests – projected by the UN to be 4.8% for 2013.
In brief, the spillover from QE tapering will trigger diversionary effects on capital inflows to Africa – after all, if better returns or yields could be attained in the United States, investors would have little incentive to seek returns elsewhere – where they may face additional risks – political instability etc. Many analysts predict South Africa, with relatively its high current account deficit of 6% of GDP, is particularly vulnerable to retrenchment of capital flows. This view is supported by the Institute of International Finance which in a June 2013 research note mark that Emerging Markets tend to suffer disproportionately because of the size and duration of outflows in times of trouble. It is to be noted however that the IIF believes that the “solid fundamentals” of EMs as a whole, of which about 30 are currently running budget surpluses, should see them through any crisis brought about by capital outflows.
Notwithstanding, there’s a lot of worry and nervousness in emerging markets and beyond as to what an exit from the Fed’s easing would mean. The IIF reports that weeks after Bernanke’s May 22nd speech which hinted of QE tapering, EM equity and bond funds have witnessed increased net outflows to the tune of $18 Billion and $7 Billion respectively. Furthermore, the reduction in potfolio equity and bond flows have pushed down EM currencies by 7%. This nervousness also seeped into the equity markets which dropped about 15% after May 22 and vindicated the South African Finance Minister Pravin Gordhan who is reputed to have remarked that QE withdrawal had “created a toxic formula of uncertainty”.
However, the Brazilian Finance Minister and the Brazilian President have been more forthright in their criticism of the US Fed whom they accuse of engaging in a currency war through QE. Evidently in the mind of many analysts, commentators et al warning of the downside risks from the Fed’s tapering or reversal of easing, are the 1987 stock market crash (which arose out of expectations the Fed was about to tighten monetary policy) and the 1994 bond market collapse after the Fed after suddenly increased rates.
Recognising these risks facing exposed emerging and developing economies, the IMF recommends that the threats to interest rates, exchange rates and asset prices from the US QE reversal could be mitigated by central banks action taken now (i.e. being proactive, not reactive) such as the case of Brazil and Indonesia whose central banks are currently deploying monetary tightening via interest rate hikes. The IMF boss, Christine Lagarde also calls for communication to manage expectations and reduce uncertainty.
As always, there are those with an opposing view, those like the Sri Lankan Finance Minister who think the market reactions have been “exaggerated”. This view may stem from the fact that markets frequently get hold of an idea with which they whip themselves into a frenzy and the Fed’s QE taper may yet turn out to be one of those times. Then again it may not, but whatever your view, few would argue with the idiom, “forewarned is forearmed”.
ECB Working Paper Series No. 1557 On the international spillovers of US Quantitative Easing
Marcel Fratzscher, Marco Lo Duca and Roland Straub, / June 2013
Ernst & Young’s attractiveness survey; Getting down to business; Africa 2013
IIF RESEARCH NOTE, Capital Flows to Emerging Market Economies, http://www.iif.com
June 26, 2013
IMF Country Report No. 11/203, THE UNITED STATES SPILLOVER REPORT – 2011 ARTICLE IV CONSULTATION
James Gruber, Emerging Market Rout Spells Opportunity, Forbes Magazine
9th June 2013
Kenneth Rapoza, Is there life after QE, Forbes Magazine
19th June 2013
Mark Carlson, A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response
Board of Governors of the Federal Reserve, November 2006
The Economist, The Fed and emerging markets The end of the affair, 15th June 2013
The Economist, What QE means for the world Positive-sum currency wars, 14th Feb 2013
The Financial Crisis, Capital Flows, and Global Liquidity
Keynote Speech by Naoyuki Shinohara, Deputy Managing Director, International Monetary Fund
Bank of Korea International Conference 2013
Seoul, Korea, June 3, 2013
United Nations, World Economic Situation and Prospects 2013 Global Outlook, http://un.org