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Can Emerging Markets Avoid A “Hot Money Meltdown”?

Can Emerging Markets Avoid A “Hot Money Meltdown”? Economy Watch

Emerging markets have been the darlings of global investors for most of the last decade. But the speculative flows into emerging markets have created highly leveraged investment and spending booms that are in danger of falling apart now that the hot money is close to drying up.

A few months ago, April to be precise, I wrote an article for a Nigerian news site entitled, Not Just by Monetary Easing. Therein, I warned of the need for emerging economies to be cautious of the hot money they are attracting, which is a direct offshoot of the quantitative easing (QE) taking place in some advanced economies like the US and Japan, and the generally loose monetary policy globally. I went further to warn of the risk of it causing a bubble in the financial market, which could burst when the easy money stops.

I noted that structural reforms, on the other hand, should be pursued to ensure long term growth, taking into cognizance the fact that monetary policy can only help in the short run. With emerging economies witnessing huge portfolio inflows during that period in the atmosphere of the loose monetary stance in advanced economies, sentiment turned positive as stock indexes reached new highs in most emerging economies. Bond yields were moderate; inflation muted; foreign reserves soared; and exchange rates were stable except where they were intentionally manipulated to gain trade advantage. It was like Christmas, except we were still in summer.

The trouble with tapering

That was of course before Federal Reserve chairman Ben Bernanke decided to go hawkish in June, suggesting that the Fed could head for a QE exit sooner than expected, signifying the halt of the $85 billion liquidity they were pumping in monthly. The reaction throughout the world was unexpected as investors moved to re-position their portfolios ahead of the coming hurricane. It triggered a major sell-off in the equities markets worldwide; the Nigerian All Share Index (ASI), which crossed 40,000 points in early June, shed close to 3000 points in 5 days in mid-June, declining by as much as 7.5 percent. Bonds prices also fell as investors exited, leading to a spike in emerging markets bond yields.

Commodities were not spared; gold especially trading at a record bearish zone. Over a trillion dollar liquidity was wiped off financial markets globally in the sell-off that resulted after Bernanke’s comment. Central banks in emerging economies moved in to protect local currencies from depreciating against the dollar, which of course resulted in a huge down-slide on exchange reserve as the formally benign inflation risk soared.

A similar scenario is ensuing now in most emerging economies as the reality of QE tapering is coldly dawning on investors with all optimism that it might still be extended further having waned. “The taper is finally here and we should all start cashing in before it’s too late” seems to be the phrase that best captures the emotion guiding investors in the financial markets of EM’s.

Emerging market currencies are now crashing as speculators gain foothold in the foreign exchange markets: the Indian rupee went down 25 percent in just three months; the Central Bank of Nigeria has been conducting a larger than usual Writing-Down Allowances (WDAs) auction to ease pressure on the Naira; and the Brazilian Real has also not been spared as it depreciated 20 percent this year. The Central Bank of Brazil recently announced a move to intervene in the foreign exchange market to the tune of $60 billion to shore up the real value. For the first time since 2002, the bank pre-announced a daily intervention plan.

The majority of these countries are still massive importers and, if currency depreciation is not checked, inflation will be imported - which clearly justifies the hyperactivity of the central banks in the exchange markets. Bourses are still in correction and foreign reserves are falling. Bond yields are spiking and Russia's sale of 10-year bonds flopped after the government offered yields below what investors demanded.

The recent happenings in the emerging economies’ financial markets should be ominous to the discerning, as it means all the positive indexes and indices earlier achieved were not due to improving fundamentals, but were basically sentiment-driven by QE in advanced economies. In short, markets have been pushed beyond fundamentals and are merely reverting back to the position it ought to be, once again laying bare the major fundamental structural faults in these economies and promoting calls for structural reforms.

So what now for policy makers?

Being a policy maker in an emerging economy could be challenging. Having to adjust macroeconomic policies intermittently at the slightest hint of external shocks arising from monetary and fiscal activities as well as the business cycle fluctuations in advanced economies, could be very thorny; and this is what policy makers in Africa and emerging economies of Asia and South America have had to grapple with over time.

Difficult periods however should come with attendant desperate measures which could be painful to implement but also necessary. This is why, aside from concentrating on structural reforms, emerging economy policy makers should look towards implementing more unconventional monetary and fiscal policies to ensure steady and balanced growth.

The Central Bank of Nigeria’s recent hike in currency reserve ratio on public funds, to moot inflationary pressure and draw back the excess liquidity in commercial banks, is one of the unconventional tools that we’ve come to see in this unpredictable period. More of this type of unconventional tool is needed. The possibility of imposing higher tax on hot money outflow and generally raising their exit barrier should also be looked into.

"Yes, this may deter foreign investment because investors generally prefer highly liquid markets with low entry and exit regulatory barriers and tax constraint; but this might be needed to stem the tide of investment outflow and ensure stable growth. Policies are more effective when they are designed to prevent wide swings in trends of indices for a more even and balanced trend contour."

Structural reforms are difficult and painful to implement. The people of Eastern Europe and South America still tell of how grueling the "shock therapy" implementation was. The policy developed by American development economist Jeffrey Sachs to curb hyperinflation and structurally transform their economies was viewed by critics as being too severe. For the countries that patiently and painfully passed through the grueling exercise however, the benefits are there for all to see.

More advanced emerging economies in the process of transition, like Brazil, India and China who are already industrialized, need to start exploring other potentials for growth as their growth prospect now appears to be slimming. China’s growth forecast has been cut to 7 percent this year while Brazil’s growth figures have been fluctuating since the financial downturn in 2008 - slowing down to 0.9 percent last year from 2.7 percent achieved the year before.

They should also look towards correcting social inequality, which is straining their policy. This should start by reforming the public sector to be more effective and corruption-free. As shown by the recent protest against public sector corruption in Brazil, people are still dissatisfied with the state of things. They can then build on this by exploring new growth potentials in manufacturing, assured that their house is already in order.

For developing economies in Africa which largely depend on the export of one or two primary products exported unrefined for revenue, full blown structural reforms are needed to diversify their economic base. A primary product exporting economy is unsustainable and the long term prospects if the status quo is maintained are bleak, which is why governments in this region should take bold steps to correct the structural faults impeding the economic diversification process. It is a painful process which requires a lot of political will and stringent measures need to be taken.

Desperate times call for desperate measures

Political ties will be severed, ethnic warlords will whip up tension, corrupt government officials will go on the offensive and there will be public angst and revolts for what would be initially viewed as anti-people policies - but like I noted earlier, these are challenging times that require desperate solutions:
"The clock is ticking and the economic emancipation leeway is gradually closing as every other continent is moving up the economic prosperity ladder. This is no time for ineffective, dithering, and lily livered government but bold and corrupt free ones who can lead their individual countries through structural reforms. Make no mistake about it, there is no other option and the consequences of dithering are dire, the earlier these long term solutions are embarked upon, the better."

This article was written by Abimbola Hakeem Omotola and originally published in Economy Watch under the title: Can Emerging Markets Avoid A "Hot-Money Meltdown"?

Tags: Ben Bernanke , Central Bank of Nigeria , Economy Watch , emerging markets , Federal Reserve , hot money flows , quantitative easing
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