FOR most of this year and the latter part of last year, central bankers and financial markets in the “emerging economies” have been hypersensitive to the possibility—inevitability, really—of an upward move on interest rates by the US Federal Reserve. James McCormack, who is the head of sovereign ratings for Fitch, thinks they shouldn’t be.
McCormack explains, “As a tightening of US monetary policy draws closer, investors are likely to focus again on emerging markets (EMs) with large external funding requirements. This will be accompanied by greater volatility as markets adjust to the change in EM external financing conditions, as happened in mid-2013 during the ‘taper tantrum,’ and as is already happening to some degree. But concerns about immediate, broad EM sovereign stresses due solely to higher US policy interest rates are misplaced.”
The reasons why EM financial markets are nervous about the eventual tightening are obvious. Higher interest rates in the US mean that external funding—i.e., foreign investment in stocks or bonds, particularly the latter—becomes more expensive. Yields on securities also increase as interest rates go up, so that makes US bonds and treasuries more attractive, and could lead to an outflow of foreign money from EM financial markets.
McCormack points out, however, that the assumptions may be based on an overestimate of the impact of “quantitative easing,” which supposedly sent “a wall of money” into EM markets.
“While intuitively appealing,” McCormack writes, “this is not borne out by US balance-of-payments data showing net acquisitions of external financial assets [i.e. capital outflows]: average quarterly US outflows were $184 billion higher in 2004-2007 than they were during the 2008-2014 QE period.” This makes sense, if we remember recent history; the period just prior to the financial crisis generated a huge amount of money from the mortgage-backed securities trade, a significant amount of which consequently found its way to foreign markets. Philippine markets were not as popular a destination then, which was frustrating for local market players and analysts at the time, but ended up indirectly helping to insulate the economy against some of the worst effects of the crisis that followed.
Part of the reason why EMs should not be as concerned as they are about the Fed, McCormack explains, is that their credit fundamentals are much stronger than they were 7-10 years ago. Where countries are still running current account deficits, he points out, their amortization is much lower, and that puts them in a much better position to withstand external shocks. Here in the Philippines, the pattern he describes is also evident; current account performance tends to vary from quarter to quarter, but the longer trend is toward lower debt and lower debt servicing requirements.
McCormack does point out a couple of risks, for which there have been some worrying signs in recent months. Persistent current account deficits—which are not a problem at the moment for the Philippines, having posted a $3.3 billion surplus in the first quarter of this year—could drive up gross external funding requirements (GXFR). In the Asean, Myanmar, Laos, Cambodia, and Vietnam have current account deficits at present, which presents some risks to the entire region as financial markets become increasingly integrated under the Asean Economic Community. The reason higher GXFR is a potential problem is that an economic downturn elsewhere in the world would obviously limit investment potential.
Another more subtle risk, but one that might have a greater impact, is if long-term bond yields in the US do not respond to higher Fed rates, what McCormack calls the “bond market conundrum.” This is counterintuitive, because the immediate result of it would be to continue to make EM securities comparatively more attractive than the US market. However, because EMs pay a premium relative to US treasuries, circumstances that keep foreign investments relatively high increase EM borrowing costs.
And of course, the world—emerging and established economies alike—is facing new uncertainties with the apparent implosion of the Greek economy after the breakdown of debt management talks with the EU. While Fitch’s McCormack may have efficiently dispensed with worries over the US Fed, there are no real precedents to the current Greek crisis. Uncertainty is bad for business, but whether or not panic for anyone other than Greeks trying to find a working ATM machine are warranted remains to be seen.