Will another taper tantrum hit emerging markets?


In early July, the yield on 10-year US Treasury bonds fell to its lowest level in four months, and equity markets plunged on fears that this year’s optimistic outlook for economic growth could hold true. Nonetheless, the dominant view is that the recent surge in inflation will be transient, allowing the US Federal Reserve to continue a smooth unwinding of its balance sheet at some point in the future.

Part of this month’s market episode dates back to February and March of this year, when U.S. long rates rose in anticipation that the Fed may soon begin to tighten monetary policy. With US President Joe Biden’s sweeping fiscal programs, new fears about inflation and economic overheating have arisen. Ten-year Treasury yields rose from less than 1.2% to almost 1.8% before stabilizing and falling back to previous levels this month.

While there was some nervousness after the June Federal Open Market Committee meeting, when some FOMC members took a more hawkish stance, the Fed nonetheless managed to keep markets cool by promising to give plenty of notice before you start cutting back on monthly bond purchases. Since then, interest rates have fallen at a noticeable pace.

Rather than worrying about another tantrum, we should be more concerned about the slow pace of vaccinations leading to an anemic post-pandemic recovery; inflation-generating commodity price increases; and economic strategies that only restore the low growth rates of the pre-pandemic era.

But uncertainties remain for emerging markets, most of which suffered from capital flight from the February-March crisis and the resulting rise in US market interest rates. While those exits have since reversed, there is still the possibility that the Fed will feel compelled to change course, leaving open the question of whether we are heading for another tantrum taper of the kind that rocked the markets. worldwide in 2013.

Recall that in June of the same year, then Fed Chairman Ben Bernanke suggested that the FOMC could soon start to slow down its bond purchases. With that one passing statement, Bernanke unwittingly started a wave of interest rate hikes and capital flight from emerging markets.

At the time, the “fragile five” – South Africa, Brazil, India, Indonesia and Turkey – had high current account deficits and heavy reliance on foreign capital inflows. For years, they had suffered the ripple effects of ultra-accommodative US monetary policies, which pushed investors to seek higher yields in emerging markets. When Bernanke raised the possibility of a gradual tightening of monetary policy, investors briefly panicked.

Another episode of capital outflows from emerging markets occurred in May 2018, when the Fed really began to reduce its holdings of assets; but this decrease, followed by a liquidation on the US bond markets and an appreciation of the dollar, was interrupted in 2019. This time, the “fragile five” had been reduced to the two fragile ones, Turkey and Argentina. , both of whom had high checking accounts. deficit and acute vulnerability to exchange rate fluctuations, due to their large volumes of foreign currency debt.

This brings us back to this year. According to the Institute of International Finance, the stock market crisis of February-March was enough to generate a significant reduction in portfolio flows from non-residents to emerging markets. Although those losses were partially recovered over the next three months, concerns of a “taper tantrum 2.0” will remain salient over the next two years, especially if it starts to look like the Fed will tighten faster than it does. it currently does.

But it’s important to remember that we are no longer in 2013. Back then, the current account deficits of the fragile five averaged around 4.4% of GDP, compared to just 0.4% today. Moreover, the flow of external resources to emerging markets in recent years has been nowhere near as large as in the years leading up to the 2013 crisis. Real exchange rates are also not as overvalued as they are. were then. With the exception of Turkey, the gross external financing needs of the five fragile countries as a proportion of foreign exchange reserves have declined considerably.

Two other mitigating factors also merit consideration. First, if stronger economic growth drives up US interest rates, positive trade ties for some emerging markets could help offset any negative financial ripple effects. Second, it’s safe to assume that the Fed will offer more appropriate “signaling” this time around, minimizing the risk of another panic episode.

What about the problem of “twin deficits” in many emerging economies? It cannot be ignored that emerging markets experienced significant capital outflows last year even as their budget deficits increased in response to the pandemic. But despite the COVID-19 crisis, emerging markets have generally been able to finance their larger budget deficits by relying on domestic investors and, in some cases, their central banks. And from the second half of 2020, purchases of government securities by non-residents in some emerging markets have started to pick up again.

Of course, since some issuance of securities denominated in foreign currencies may still be necessary, the risks associated with fluctuating currency flows have not been fully eliminated. Countries like Colombia and Chile still have relatively high dollar-denominated debt levels, and in some emerging markets, portfolio inflows will remain crucial to finance budget deficits.

But, at the end of the day, the biggest risks emerging markets face lie elsewhere. Rather than worrying about another tantrum, we should be more concerned about the slow pace of vaccinations leading to anemic post-pandemic recovery; inflation-generating commodity price increases; and economic strategies that only restore the low growth rates of the pre-pandemic era.

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