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.