CAN FED IGNORE EMERGING MARKETS ?

This has the makings of a grave policy error: a repeat of the dramatic events in the autumn of 1998 at best; a full-blown debacle and a slide into a second leg of the Long Slump at worst.

Emerging markets are now big enough to drag down the global economy. As Indonesia, India, Ukraine, Brazil, Turkey, Venezuela, South Africa, Russia, Thailand and Kazakhstan try to shore up their currencies, the effect is ricocheting back into the advanced world in higher borrowing costs. Even China felt compelled to sell $20bn of US Treasuries in July.

“They are running down reserves by selling US and European bonds, leading to a self-reinforcing feedback loop,” said Simon Derrick from BNY Mellon.

We are told that emerging markets are more resilient than in past crises because they have $9 trillion of reserves. But any use of that treasure to defend the exchange rate entails monetary tightening, and therefore inflicts a  shock on countries already in trouble.

We are also told that they borrow in their own currencies these days, immune to the sort of dollar squeeze that caused such havoc in the early 1980s and the mid-1990s. This is true, but double-edged. India, Brazil and others will surely be tempted to stop fighting markets, let their currencies slide and inflict the pain on foreigners – that is to say, on your pension fund.

Mirza Baig from BNP Paribas advises them to embrace devaluation, calling it futile to defend quasi-pegs. “The costs of fighting are going out of control,” he said.

Mr Baig said foreigners bear 90pc of the currency risk in Malaysia, 81pc in Thailand, 79pc in Korea and 74pc in India. So let them take the haircut. Should these countries take that course, they will inflict a deflationary trade shock on the West. The eurozone is in no fit state to handle that. Nor is Britain.

We are in entirely uncharted waters. Emerging markets were less than 15pc of global GDP in the early 1980s, when tightening by the Volcker Fed brought Latin America crashing down. That was an ugly episode for Western banks, but easily contained. China was then, shut off from the world. The Soviet Union and its satellites formed a closed system.

The picture was already very different by the mid-1990s, when ex-Communists had joined the party. By then emerging markets had grown to a third of global GDP, big enough to rock the boat, as Fed chair Alan Greenspan discovered after Russia’s default in August 1998.

Mr Greenspan became worried enough to canvas Fed governors on the need for a response at the Jackson Hole conclave that month. The Fed cut rates in September but it was not enough to stop the crisis spinning out of control as currencies crashed across East Asia, and the pre-EMU “convergence play” in Europe reversed violently.

The New York Fed was forced to intervene in October 1998, rescuing the hedge fund Long Term Capital Management. The Fed cut rates again in October and November. Mr Greenspan said “the probability of systemic collapse was sufficiently large to make us very uncomfortable about doing nothing”.

If the stakes were high then, they are higher now. Emerging markets are half the world economy, according to IMF data. The “power ratio” is no longer 1:2, it is 1:1. Those who fell in love with the BRICS and mini-BRICS in the boom were entirely right to claim that an economic revolution was taking place.

Yet all we heard from Jackson Hole this time were dismissive comments that the emerging market rout is not the Fed’s problem. “Other countries simply have to take that as a reality and adjust to us,” said Dennis Lockhart, the Atlanta Fed chief. Terrence Checki from the New York Fed said “there is no master stroke that will insulate countries from financial spillovers”.

The talk for Fed corridors strikes me as dangerously insouciant. The bank has made a series of errors over the past six years, the result of a “closed macro-economy model” that fails to take full account of global interactions. It failed to anticipate how jamming on the brakes before the Lehman crash would trigger a scramble for dollars, igniting a conflagration. The bank played a key role in setting off later spasms of the EMU debt crsis with hawkish talk, each time forced to retreat later.

“The big risk is that Fed tapering will spark a rush for US dollars. That is when the Fed will stop being complacent,” said Lars Christensen from Danske Bank. “Central banks around the world think they have been doing something they shouldn’t do with all this stimulus, and they want to unwind it as quickly as possible. But the danger is that they will go too far and trigger a relapse like 1937.”

The Fed has a duty of care to emerging markets, since its own hands are hardly clean. Zero rates and quantitative easing were the cause of dollar liquidity flooding these countries. It was the biggest reason why net capitals flows into emerging markets doubled from $4 trillion to $8 trillion after 2008, much of it wasted in a late cycle blow-off.

Yes, China, Brazil, India and others handled the liquidity bath badly. They ramped up credit without generating much worthwhile growth. In China’s case the economic return on loan growth has collapsed from a ratio of 0.85 to 0.17. The diminishing returns have shrunk to almost nothing.

The credit boom disguised the underlying rot as the BRICS club lost labour competitiveness. Every case is different but nowhere was myth so divorced from reality as in Brazil. The country is languishing at 130th place in the World Bank’s rankings for ease of doing business, industrial output is still 3pc below pre-Lehman levels and it has lost its way with dependence on iron ore and commodity exports.

As Matt King from Citigroup says in a pithy note, tourists have discovered that “reality is less good than the brochure” in emerging markets and now they are pining for home. “Don’t all come home at once. The exits are small,” he warned.

One cannot blame the US for the failings of these countries, yet Ben Bernanke and his successor will still have to live with the consequences. Globalization has entrapped the Fed. Like it or not, the Fed is the world’s monetary superpower.

The exodus of money from emerging markets that we have seen so far is nothing compared with what could happen if this episode is mishandled. The rapid escalation towards a Western missile strike on Syria is bringing matters to a head fast, with talk of a spike in crude oil prices to $150 a barrels setting off its own chain reaction.

If the Fed really thinks that the rest of the world will have to “adjust to us” as it insists on draining global liquidity come what may, it may have a very rude surprise, yet again

BRICS STANDS FOR BRAZIL, RUSSIA, INDIA,CHINA, SOUTH AFRICA.

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