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Home > Capital Markets Viewpoints > US Monetary Policy And Its Impact On China and Emerging Economies

Capital Markets Viewpoints

US Monetary Policy And Its Impact On China and Emerging Economies

by Simon Derrick

US Monetary Policy Since 1988 and Emerging Markets

The financial world is going through an interesting and volatile period.1 Not only are we seeing economic power moving eastward with the rise of China and Asian economies, the United States is looking to transition away from extraordinary monetary policies as its economy improves, while the central banks in Japan and the United Kingdom press on with quantitative easing. The predominant force that perturbed global markets through the first quarter of 2014 was undoubtedly US monetary policy and market expectations—both in emerging and developed markets— because of emerging market concerns about the tapering off of quantitative easing (QE) by the US Federal Reserve (the Fed).

The Fed has a history of eventful summer months, and we have seen fallout for emerging markets before now from changes in US monetary policy. In the summer of 1998—in the midst of an emerging market crisis—the then Fed Chairman Alan Greenspan gave his semi-annual testimony to the Senate’s Committee on Banking, Housing, and Urban Affairs. He stated: “The Committee recognizes that significant risks attend the outlook: One is that the impending constraint from domestic labor markets could bind more abruptly than it has to date, intensifying inflation pressures. The other is the potential for further adverse developments abroad, which could reduce the demand for US goods and services more sharply than anticipated and which would thereby ease pressures on labor markets. While we expect that the situation will develop relatively smoothly, the Committee believes that, given the current tightness in labor markets, the potential for accelerating inflation is probably greater than the risk of protracted, excessive weakness in the economy.”2

In the weeks following Greenspan’s testimony the crisis spread to Russia, triggering the Russian default, and, by the following Jackson Hole gathering, the Fed had been forced to reverse policy and go for a much more accommodative policy. Arguably, the “loose money,” easy credit approach which the Fed then deployed also had a major role in triggering the dot.com boom and subsequent bust in 2001—quite a chain of events.

More recently, the flow of funds to emerging markets triggered by the Fed’s accommodative policies, introduced after the financial crash of 2008, began a multiyear bull run that only started to slow down in the summer of 2011. At that point India’s rate of growth slowed and there were obvious signs that its economy was struggling. The economies of Brazil and Turkey also started to stutter badly. The structural weaknesses in their economies were thrown into sharp and unflattering focus by the slowing down in fund flows. The slowdown continued through 2012, even though most of Asia seemed to be holding steady despite the troubles in India, Turkey, and Brazil.

Notwithstanding these external developments, by May 2013 Fed chairman Ben Bernanke had begun to talk openly about the likelihood that the Fed would soon start reducing its purchases of US bonds and securities under its quantitative easing program. This left those emerging market nations that were running significant current account deficits exposed to the threat of US interest rate hikes. As a result, a number of Asian (and other) currencies started to plunge against the US dollar as soon as Bernanke indicated that “tapering” was under discussion. This was followed, in turn, by a number of emerging market central banks stepping into their local currency markets in order to support their own currencies (despite the fact that Bernanke was already backing away from his hawkish stance by as early as July 10). Between the start of 2013 and September, when the Federal Reserve put off tapering its bond market purchases until a later meeting, India’s reserves had shrunk by US$17 billion and Indonesia’s by US$14 billion.

Emerging Market Reserves and the US Dollar

The historic connection between the Fed running a highly accommodative monetary policy and the flow of funds into emerging markets is clear, as has been the negative effect on emerging markets since the Fed started to talk about tightening policy. What is less clear is the feedback loop back into US markets. According to the latest IMF COFER3 data (as of the end of the first quarter of 2013), around 60% of the known holdings of the emerging market nations’ foreign exchange reserves are invested in US government and quasi-government securities along with dollar deposits.

However, if an emerging market central bank needs to defend its currency, it has to sell underlying assets to fund a foray into the foreign exchange markets to support its currency. Little wonder then that the periods of the most intense currency support operations by emerging market nations in 2013 coincided with sharp upward pressure on the yields of US government securities. Consistent with this, US yields also eased somewhat as the sharp emerging market crisis began to ease during September 2013.

There is, however, another longer-term issue that needs to be considered. This is the position that the largest foreign exchange reserve holders now find themselves in. After 11 years of highly accommodative monetary policy settings in the United States (since the start of 2002 the average level of headline inflation there has been 2.37%, while the average Fed funds target rate has been just 1.79%), the emerging market nations have seen their combined currency reserves jump (according to the IMF COFER data) from around US$800 billion to (as of the end of the second quarter of 2013) around US$7.47 trillion, an eightfold increase. China, of course, led the way, with its foreign exchange reserves rising from around US$227 billion to around US$3.6 trillion.

That is a huge volume of currency reserves, and they have to be used somehow. As already noted, some 60% of the known allocation of that pool is held in the US dollar. The remaining 40% of emerging market foreign exchange reserves are allocated to other currencies, with around 24% going into the euro, while sterling, the yen, the Australian dollar, and the Canadian dollar have also all benefited from emerging market diversification out of dollars. The natural home for this money is conservative assets, such as government bonds.

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Further reading

Books

  • Authers, John. Europe’s Financial Crisis: A Short Guide to How the Euro Fell Into Crisis and the Consequences for the World. Upper Saddle River, NJ: Pearson Education/FT Press, 2013.
  • Davis, Norman. Vanished Kingdoms: The Rise and Fall of States and Nations. New York: Penguin, 2012.
  • McLean, Bethany, and Joe Nocera. All the Devils Are Here: The Hidden History of the Financial Crisis. New York: Portfolio/Penguin, 2010.

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