The “sword of Damocles for emerging markets”

Just passing along a brief blurb (plus some of my thoughts attached) from a recent SocGen note which highlights the risks in emerging markets if indeed the Fed is set to begin tapering in March, 2014.  We got a brief glimpse of this risk earlier this year when emerging markets panicked over the potential taper (via SocGen):

Fed policy, a sword of Damocles for emerging markets

Following the Fed’s decision in September to postpone tapering, emerging markets (EM) rebounded strongly. But this relief rally has now stalled, as investors are cautious about the central bank’s next move (see chart). Indeed the latest FOMC meeting confirmed the Fed’s bias for tapering and the very good employment report released last Friday reinforces our economists’ expectation of a March 2014 taper. The threat of rising global yields is a key downside risk for EM assets near term. Higher bond yields should trigger portfolio rebalancing and the “repricing of risk could spark a run by investors holding speculative positions”, says the IMF. The shock will be further amplified in countries with external imbalances and vulnerable financial systems.”

The reason this is such a big risk in some emerging markets simple.  Emerging market investors are concerned that the Fed will effectively increase global borrowing costs which could hurt highly indebted emerging market economies:

“In the past four years, credit growth has been excessive in many EM (exceeding 15% p.a. and outpacing GDP growth in several countries). While public debt generally remains under control, private sector debt has built up rapidly, especially in emerging Asia. The fast rise in household debt in some countries like Thailand and Malaysia is a growing cause for concern. More worrying is the leverage of China’s corporate sector, now one of the most indebted in the world (c.150% of GDP). A prolonged economic slowdown could trigger a surge in NPLs in EM where debt levels have run up significantly and asset bubbles have formed. The banks which are the most exposed to these distressed loans could threaten the stability of EM financial systems and their economies.”

I am not sure anyone really knows how much the Fed’s QE and ZIRP programs has contributed to foreign borrowing via carry trades or other related leverage based market dynamics.  But this is just one of the many unintended consequences from a program that probably should have been ended long ago and now has become a problem corralling.


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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  1. This is really interesting. Unintended consequences indeed. The Fed might have been trying to fuel a debt releveraging here and ended up doing it in places they weren’t looking. And now they have to worry about deflating other economies. What a mess!

  2. I think EM get smashed once the tightening begins. There’s no other way really…. I think the whole point of QE was to create hot money flows into EM if you ask me.

  3. ignorant question I know. But helps to understand. Do most of the “emerging markets” have
    their own currency? If so, which ones and which don’t. As we know, if a country is
    “monetarily” sovereign, it is private debt which is the potential problem, not public debt.

  4. Mosrt of them do but the problem is that a big portion of this debt is foreign denominated

  5. This is similar dynamic to the 97 asian financial crisis if I understand correctly.

  6. What about credit growth in the US, in the form of US Debt, subprime car loans, student loans etc ? I get it, the US Debt is a funny thing because of the sovereign currency stuff, but all of this is bound to have serious consequences at some point.

    It is interesting how these reports continue to think that the main reason for QE is economic stimulus (as opposed to continued support for the still fragile financial system), and that there is a recovery around the corner (as usual, linear extrapolation of the most recent history … it never fails).

  7. With Federal debt levels where they are, the Fed can never “tighten”, as it would cause interest costs on the debt to spiral out of control, paradoxically, worsening inflation.

  8. … and we now have Janet Yellen at the Fed, a self-absorbed academic who is more intent in proving her theories right than testing them honestly. She will do immense damage just to prove a point.

  9. I don’t think we’re there yet, but we’re close. I’ve actually made that very same fiscalist argument on this site many times. I do think we can tighten now, but it would be rather painful

  10. Interest costs are what, 5% of the budget? Or less than 2% of GDP? I think the govt can handle a bit of a bump in interest costs.

  11. If you have $10T in debt coming due over the next few years, and 5 pct interest costs, that’s $500 billion, right?
    That would be 15 pct of the budget, or about what we spend now in discretionary spending.
    Would that be a problem?

  12. 1-year rate
    2000: 6.09
    1990: 7.2
    1990: 7.8.

    Just considering the possibility. Are you ruling out those types of rates?

  13. IMO, conditions are much different than they were in 1990, but that’s just me.

  14. The CBO is calling for average 4% Treasury rates by the early 2020s. It is this assumption and to a far lesser extent medical costs, that drive the spiraling budget deficits they later project. The Fed can completely control Treasury rates across the yield curve. So they will not allow this to happen, though we could see modestly higher rates (10 year perhaps reaching 4%) in the coming years if the economy strengthens a bit as a deleveraging consumer starting levering up again. But then we’ll go into another recession and the 10 year will have a 1 handle again. Japan-lite.

  15. Yes, but we don’t know what interest rates will be like in 2015.
    It would be safe to assume for today’s policy purposes that they will return to a more normal range.
    Or else make the case that we are moving into a time in which rates will be held low so long as we have this kind of federal debt.

  16. A 10yr tbond yield at 5% in 2015 doesn’t sound unreasonable, but the avg rate at which the debt is being rolled over will likely be lower (depending on such things as the shape of the yield curve and where on the curve the new bonds are being issued).

    In any event, my main point is that I think the govt can handle moderately higher rates.

  17. Exactly what i have been saying for years. Think about it, whether Greenspan, Bernanke or Yellen are right or wrong doesn’t really matter as they are essentially dictators and have the ability to continually double down on their bet. What if they are wrong?????

    At this point, it’s not far fetched to state that many of Greenspan’s theories were flawed and caused serious long term damage to the global economy and society as a whole. Isn’t it troubling that there is a possibility that Bernanke’s and Yellen’s approach to the current environment may be wrong as well? Think about it, even if the magnitude of their mis-diagnosis is not too large the fact that they get to double down over and over again can be very damaging.

    I for one think they are making big mistakes. There are some that dont agree but there are others, a lot smarter than me, who also think we are making huge policy mistakes with generational implications and this guys get to double down????? SCARY!!!!!

    They are all academics and very accomplished ones for sure. It would take a lot of courage to all of a sudden say that pretty much everything they studied, wrote about and believed in during their very long successful academic career was flawed and therefore current solution to the problem is actually a big part of the problem. Really really scary stuff. I believe this is what is happening right in front of our eyes. Thoughts?

  18. Agreed. It’s dangerous to give the reigns of the most powerful central bank into the hands of a few crazy academics.

  19. Which is exactly what Sumner wants to do. In fact he doesnt want it to be a few he wants it to be Chuck Norris all by himself.