There is suddenly a very intense conversation that is taking place within the ranks of the emerging markets. The Fed decision to delay the tapering process has been seen as something of a reprieve and now the question is what these nations can do with this break. The crux of the situation is relatively simply stated—the loose monetary policy of the U.S. was created by historically low interest rates and a series of extraordinary moves designed to bolster the economy by holding long-term rates as low as possible. This same tactic has been employed in Europe and in its most drastic form in Japan. The investor reacted to all this predictably. There was no real opportunity to make much of a return in the U.S. or European market so money took off for greener pastures and those were to be found in the emerging markets. To make matters that much more complex, there are restrictions on investment in some of these states, most notably China. The "hot money" in search of decent returns was essentially channeled into states such as Brazil, India, Turkey and others that soon became the darlings of the investment community. For the most part this influx of cash was welcome and it contributed to the rapid growth these nations were experiencing. Remember a few years ago when the BRICs were all the rage? At the time there was concern about the impact all this cash was having on inflation and the reaction of the central banks actually made things a little worse. The response to inflation was to raise interest rates and that just made these economies all the more appealing.
Then the Fed started to talk about reducing all this economic assistance and the investor's mood changed quickly. Now there is the promise of higher rates, and in markets that were considered more secure and reliable. The flood of cash out of the emerging markets threatened to be even more drastic than the flood in. That was until the Fed seemed to reverse course. The investors are now stuck in a kind of self-imposed limbo as they try to figure out the next move. For the time being the emerging markets are not seeing the exodus that was starting to occur. The question is what they should do now. The money that was finding its way into these economies has remained for the time being, but nobody expects this to last. The Fed will eventually taper and the hot money will flee in search of better rates and more security in the U.S. and Europe. This is going to happen, although it is not altogether clear when. How do the emerging market states prepare now that they have been given a short breather?
Analysis: There are not all that many options and they will be hard to put into effect in the short time that may be available. It comes down to two broad strategies. The first is to figure out a way to keep attracting that foreign investment despite the higher rates that may be developing in the U.S. and Europe. The second is to more dramatically expand the growth of the domestic economy—both in terms of consumer activity and domestic investment. The discussions right now revolve around what the foreign investor wants to see in these nations. It starts with a decent return and that has many central banks considering further rate increases as this makes putting money in these countries more appealing. The problem with that strategy is that higher interest rates will slow the development of domestic growth, as loans will be more expensive. If the plan is to bolster the growth of the private sector, it would make more sense to lower the interest rates, but that chases away the investor seeking higher returns. The country then has to make a choice. The fastest way to fend off decline is to concentrate on attracting the attention of the investor, but that just extends the vulnerability to that outside funding.
- Chris Kuehl, PhD, NACM Economist
This article was originally published in today's edition of FCIB's Strategic Global Intelligence Briefs. To learn more about FCIB, click here.