posted August 26, 2014
US Federal Reserve vs. Emerging Markets

The United States Federal Reserve Chair, Janet Yellen, testified before the U.S. Congress on July 15-16. The central focus of her testimony was to confirm that U.S. “quantitative easing” (QE) programs, which have been in effect for more than five years now since 2009, will end this year. While confirming the end of QE this year, Yellen for the first time also suggested that U.S. interest rates may also begin rising soon. While U.S. rates will remain low for the next several months, a further rise in U.S. interest rates may be coming, perhaps as soon as 2015, according to Yellen. Other advanced economy central banks, such as the Bank of England, now suggest their rates may also rise perhaps as soon as November 2014.

The imminent end of QE, and the approaching rise in rates, will have a particularly severe impact on emerging market economies (EMEs)—not only in terms of real economic growth but, even more so, on the financial stability of the EMEs.

In a preceding Part 1 analysis of the future of EMEs (see ‘Is the Global Economic Crisis Shifting to Emerging Markets?’), the impact of U.S. central bank policies on EMEs since 2009 was considered. Federal Reserve QE and near zero rates since 2009 resulted in a massive global money liquidity injection by the Fed, it was argued, much of which flowed out of the U.S. economy into EMEs and offshore financial markets. That outflow did little to help the U.S., Europe, and Japan economic recoveries. The U.S. economy has bounced along the bottom with three bouts of zero or negative GDP growth since 2011; the Eurozone economy experienced a double dip recession, and the Japanese economy a triple dip recession. In contrast to the minimal impact on the U.S. and other advanced economies (AEs), the massive Fed money injection that began in 2009 contributed significantly to EME robust economic growth from 2010 to 2013.

As the U.S. Federal Reserve now reverses the free money policies of the past five years, the opposite impact on EME real economic growth will soon occur, it was argued in Part 1.

But a second, perhaps even more destabilizing effect on EMEs is about to occur as U.S. Fed monetary policy shifts. As this Part 2 analysis will argue, the EME’s are likely to experience increasing financial instability in the months immediately ahead, in addition to the slower economic real growth. Moreover, that coming financial instability may prove far more severe than central bankers and mainstream economists now anticipate.

Why Fed QE & Zero Rates Are Ending

The U.S. Federal Reserve, and the central bankers in the U.K. and later Eurozone and Japan, have known full well that the massive money injection policies that they introduced in 2009 would have little effect on stimulating their real economies. So why did the Fed and other central banks inject more than US$20 trillion in money and liquidity into the global economy since 2009?

The justification for QE and zero rates peddled to the public since 2009 has been that QE and zero rates would generate real economic recovery. But that was merely the ‘cover’ for the public to accept the massive free money bailouts provided to the bankers, at a time during which fiscal austerity was simultaneously being imposed on consumer and working class households in general. There is very little evidence that QE and zero rates did much to stimulate the real economies of the U.S. and other AEs over the past five years. QE and zero rates have had nothing to do with reducing unemployment, restarting the depressed U.S. housing sector, or generating real economic recovery in general.

The function of QE and zero rates has always been to rescue the collapsing private banking system; that is, to bail out banks and big investors, pure and simple. The ‘free money’ produced by the QEs and near zero rates of the past half decade saved the global capitalist banking system.

The QE and zero rates bailout of banks worked something like this: the tens of trillions of dollars in free money initially from the Fed in the form of QE and zero rates first offset the massive losses on bank balance sheets as new accounting entries. Phony government ‘stress tests’ of the banks and suspension of accurate reporting of bank losses in 2009 both also created the false impression to the public banks weren’t as bad off as they in fact were in 2009. All the above allowed bank stock prices to begin to recover after 2009, thereby offsetting some of the bank losses. But that was only the beginning.

The trillions of dollars in Fed-provided excess liquid reserves subsequently held by the banks was then used by the banks to generate rapid bank profit recovery: banks borrowed from the Fed at no cost and loaned out the Fed money to multinational corporations, hedge funds, equity firms, and other investors who borrowed the free money from the banks who borrowed from the Fed. Shadow banks and investors then paid banks a healthy interest of 5-15 percent on their borrowed money, and then turned around and re-invested the borrowed money in global stocks, bonds, derivatives, properties, etc., worldwide, producing even greater rates of return and creating a host of new financial asset bubbles in the process. But profits from a healthy bank interest rate ‘spread’ was still not all. Private banks were themselves encouraged by the Fed to directly invest in EMEs and to speculate directly once again in financial asset markets as well — both offshore and on — thus generating still more bank profits.

After five years of this, the once failing private banks in the U.S. were again fat with profits and flush with cash. But in the process, Fed generated ‘hot’ money flowed into EMEs and their financial markets. The stimulating of the EMEs and financial markets was thus an integral part of the banking system rescue plan. Global financial asset markets boomed, EME economies grew, and AE banks profits and balance sheets fully recovered and then some. But all this was not achieved without certain costs incurred along the way—costs which may soon have to be paid.

The Costs of Global Banking System Rescue

The “costs” of the bailout are: First, the creation of global financial asset bubbles — in stocks, corporate junk bonds, leveraged loans, real estate properties in several key markets, foreign currencies inflation, CLO derivatives, and other financial assets. Some of these bubbles are now close to bursting, the consequences of which for a still weak global recovery are essentially unknown but could prove even more severe than in 2008.

A second major cost is that financial institutions — banks, shadow banks, and investors alike — have grown “addicted” to the free money. After five years of free money, it is part of their investment planning. They depend on it. It therefore may be very difficult to wean them off of it. The negative impact on the psychology of investors may prove more severe and more swift than is now estimated, once the free money spigot is turned off.

Take the QE “punchbowl ladle” away and investors could throw another QE tantrum, as they did last year in mid-2013 in response to the mere suggestion of possibly ending QE by the Federal Reserve.
That investor “QE temper tantrum” had a particularly severe effect on EMEs. Investors started to pull their money and capital out of EMEs in droves last spring 2013. EME capital flight followed, as did sharp declines in EME currencies and the slowing of foreign direct investment into the EMEs. EME
governments responded to the capital flight and collapsing currencies in 2013 by raising their own domestic interest rates. That temporarily stemmed the tide. But rate rises, slower direct investment, and capital outflow all began to slow EME real economies, sharply in some cases, as was described previously in Part 1.

The Fed quickly pulled back from its QE taper in the summer of 2013 and announced that ending QE was not what it meant. The EMEs recovered somewhat. The Fed then late summer 2013 suggested reducing QE was again “on.” A similar negative reaction occurred in the EMEs, as did still another when the Fed actually started reducing QE purchases at the end of 2013. This “stop-go” concerning QE effects on EMEs has continued over the past year, from mid-2013 to mid-2014. EME economic indicators have been bouncing up and down. But “Stop-go” is about to become simply “stop.” And that means “down.”

If global investors and EMEs underwent a QE “taper tantrum” in the past year over the mere suggestion of the drawdown of QE by the U.S. Fed, what might happen when the Fed’s current QE actually does end? And what happens thereafter in the event of a rise in U.S. interest rates, an even more significant event? Will the “tantrum” become a “cold turkey” free money addict’s withdrawal? It is one thing to take the QE “punchbowl ladle” away from investors; it is another to drain the free money bowl itself by raising interest rates.

Whatever the response to the end of QE and zero rates that will occur over the course of the coming year, one thing is abundantly clear: the EMEs are highly sensitive to Fed policy shifts and QE. They will likely prove even more sensitive to Fed interest rate hikes once they begin.

The possible extreme reaction by the EMEs to the U.S. Fed’s free money policy reversal leads to the third “cost” of the past five years of the Fed’s QE plus zero rates engineered bank bailout. Like the first two costs—i.e. the financial bubbles and the addiction of investors to free money—the third cost is EMEs having loaded up on excess debt since 2010. Debt is the other side of the coin of the free “hot” money and credit that flowed into the EMEs and financial markets since 2010.

Debt, Fragility, & EME Financial Instability

The best predictor of future financial instability is excess Debt. Both recent and past history shows that the greater the debt buildup and debt accumulation, the greater the financial instability potential and the more severe the eventual eruption of financial instability.

Other factors besides debt play a role in financial instability potential: the ability to generate cash to continue to service the mountain of accumulated debt, and the character of the various terms and conditions associated with debt repayment. Financial instability rises when the terms of debt repayment are onerous, when the debt cannot be easily refinanced, and when the rates and term of the debt payments are difficult. When economies slow and recessions occur, the ability to raise revenue and cash to repay debt becomes more difficult; earnings and sources of liquidity with which to repay debt decline; and terms and conditions become more unattractive for borrowers. So the greater the debt the greater the financial fragility, all things equal.

The problem is that the EMEs, including China, have taken on mountains of debt during their 2010-2013 rapid growth phase when credit flowed out of the US and AEs in the trillions into the EMEs. As a result of the excess debt buildup since 2010, the EMEs have become therefore even more financially fragile than in 2008. That means once the Fed ends QE and starts raising rates in earnest, not only will EMEs real economies start to slow further—as capital flight, currency declines, reduced money inflows, etc., intensify—but the EMEs current huge debt overhang produced by five years of ‘hot’ money and credit inflows will prove difficult to manage and pay for corporations in the EMEs. Defaults will accelerate. Financial asset prices will in turn decline still further, and growing financial instability will exacerbate further an economic slowdown already in progress.

Ever since the prospect of the U.S. Fed ending QE was first raised last year, like a spinning top the EMEs have been economically and financially ‘wobbling’ ever since. The wobble may worsen as QE soon officially ends. And the wobble will almost certainly result in unpredictably gyrations should US interest rates begin to rise.

So how deep is the debt accumulation in the EMEs?

Total global debt levels have risen since 2008-09: from approximately US$205 trillion worldwide to about US$245 trillion today, i.e. in just the past five years, according to a report released last June 2014 by the Bank of International Settlements(BIS) in Geneva, Switzerland.

This US$40 trillion additional global debt reflects a rise mostly in corporate debt since 2008, and corporate debt in emerging market economies (EMEs) in particular.

In the advanced economies of the U.S., Europe, Japan, and others, AE total debt rose from approximately US$135 trillion at the end of 2007 to about US$150 trillion at the end of 2013. That’s about US$15 trillion. But virtually all of that gain has been government debt. AE corporate debt and household debt, in contrast, remained roughly at 2007 levels at the end of 2013. That the private sector debt in the U.S. and AEs has not “deleveraged” (been reduced) is itself a significant problem to the global economy, apart from the EMEs. No net deleveraging over the past five years means that, while businesses and households have not grown more indebted since 2009, neither have they been able to shed the debt previously accumulated. They thus remain financially fragile, although that fragility has not worsened. The continuing high levels of private debt, and household debt in particular in the U.S., and AEs in general, likely explains the difficulty the US and AEs have in generating a sustained increase in consumer spending—a problem which has kept their recoveries in a long term state of stagnant to modest growth at best, while producing repeated short economic relapses in GDP and occasional double dip recessions.

The same BIS data show a picture fundamentally different in the EMEs. In contrast to the $15 trillion AE total debt increase—which was virtually all government debt— EME total debt has increased by $25 trillion. That US$25 trillion total represents very little EME government debt, which has remained relatively stable in the US$22- 25 trillion range in the past five years. Moreover, the EME debt increase has occurred primarily in private corporate sector debt. EME Nonfinancial corporate debt alone rose from about US$30 trillion at the end of 2007 to more than US$47 trillion today.

In its latest 2014 Report, the BIS has concluded that “dangerous new asset bubbles” have been forming in the global economy”. Debt levels in the EMEs in particular “are well above thresholds that indicate potential trouble”. And the greatest debt buildup has occurred, according to the BIS, in China, which has become the “home to an outsized financial boom”.

What the BIS data confirms is that the massive liquidity creation by the U.S. Fed and other central banks in the AEs between 2008-2013, flowed mostly into the EMEs since 2009. EME credit inflow, and therefore debt, rose by US$25 trillion—virtually all corporate debt. Not even half the size of the U.S. and other AE economies in GDP terms, the EMEs debt has risen almost twice that of the AEs since 2007—i.e. US$25 trillion vs. US$15 trillion.

As the U.S. Federal Reserve now begins reducing that credit flow by first ending QE, and then by further raising interest rates, the hot money will begin flowing back from the EMEs to the US and AEs. That has already begun, albeit only intermittently and interrupted over the past year. The U.S. Fed policy reversal in progress will end that interrupted pattern. That Fed policy will cause continued downward pressure on EME currencies, which in turn will generate capital flight again and lower foreign direct investment into the EMEs. The EMEs will continue to try to stem these developments by raising domestic interest rates. All the above will tend to slow economic growth further in the EMEs.

But there will be an additional financial instability effect as a consequence of the above developments set in motion by the U.S. Fed policy shift. As money and liquidity flows reverse (now from the EMEs to AEs) in response to Fed policy changes, the previous massive EME debt buildup accumulated from 2010 to 2013 will still have to be paid. EME slowing economies and slowing exports will make it more difficult to do so. Those EMEs most in debt, most dependent on continuing AE credit, and most dependent on export revenues to pay for debt will find it most difficult to deal with their excess debt load once the US Fed policy reversal accelerates.

Just as prior Fed policy of QE and zero rates provided the EMEs with a massive credit ‘punchbowl’ from 2010 to 2013, now as that punchbowl is taken away by the U.S. central bank, the EMEs may become the more unstable sector in the global capitalist system—quite the opposite of the case from 2010 to 2013.
The global economic crisis therefore promises to shift, to ‘morph’ once again, from the initial focal point in the U.S. and U.K. economies in 2008-09, to Europe and Japan in 2010-2013, and now in the latest phase: to the EMEs in 2014 and beyond.

Dr. Jack Rasmus
July 2014

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