Step forward Janet Yellen, the first central banker to the world. The US Federal Reserve she chairs kept rates on hold last week even while the US economy outstripped Fed forecasts and the country almost reached its definition of full employment. Rather than focus on the US recovery, Ms Yellen stressed "the outlook abroad": the impact of Chinese and emerging-market troubles on financial markets.
Americans need not worry: this is not the creation of the Universal Reserve, where the dollar’s role as the world’s main currency trumps domestic monetary needs. Rather, Ms Yellen and her colleagues worry that China’s slowdown is affecting the US economy via a stronger currency and volatile markets.
Yet the way investors reacted suggested they have a globally-minded Fed, wary of recreating the troubles kindled for emerging markets in the past by higher US interest rates. Emerging-market equities, currencies and bonds rallied, while credit-default swap spreads fell.
Usual mistake
Meanwhile, shares in developed markets fell back as the dollar weakened, and investors made the usual mistake of assuming the Fed knows best; when it worries, they do too.
Does this signal a major change in Fed behaviour? The Fed has tended to ignore troubles in emerging markets until they arrive on US shores. Consider the 1990s: the Fed’s 1994 rate rises contributed to Mexico’s Tequila Crisis, but the Fed did not feel obliged to help avoid it. In 1997 the Thai baht’s tie to the dollar was finally cut, but the Fed did not ease monetary policy as the Asian crisis spread, until the Russian default a year later threatened the US financial system.
Some things have changed. Emerging markets are now half the world economy and more than half US exports. The direct effect on the US from weaker demand and currencies in emerging markets is bigger. But since the first emerging-market crisis in the 1820s, the real threat to the developed world was financial. The exit of hot money and capital flight from emerging markets suggests this remains the danger.
In some important respects, this time is different. None of the big emerging markets have fixed exchange rates, so their currencies have taken some of the financial strain. Foreign currency reserves of emerging markets are bigger than ever before, too. The strongest countries can afford to offset capital withdrawals even at quite high levels for years, if they wish.
This could be good news for developed markets. Take the recycling of petrodollars. In the past, money flowed from rich countries to oil nations. To avoid currency appreciation, the money was promptly sent back, to be invested in treasury bonds or equity and property ventures. With cheap oil, consumers in rich countries have more money in their pockets, but oil nations are selling down their investments to maintain lifestyles and prop up currencies. The effects are intertwined. Selling bonds pushes yields up and valuation multiples down. But if consumers spend the extra cash, corporate revenues and profits should rise and developed economies improve. The rise in earnings offsets a lower price-to-earnings multiple, Main street benefits and Wall Street is fine.
Reverse
Something similar applies to non-oil reserves in emerging markets, mostly held in US bonds. As flows go into reverse, they sell their holdings, prompting
Deutsche Bank
economists to talk of “quantitative tightening”, as central bank sales in merging markets exert the opposite pressure to the Fed’s bond buying.
This is only half the story. Every dollar of sales by, say, the People's Bank of China, gives a dollar to someone taking money out of the country. If is invested, it offsets the effect of the official sale. If spent, it increases demand in the developed world.
There is scope for dangerous discontinuities. As well as the uncertainty on whether consumers will spend or save, a move from official sector to private investors could lead to major shifts in the type of assets held, and big short-term price swings.
The hope is that the imbalances built up when investors were overenthusiastic about emerging markets can be unwound without prompting bank failures, recessions or defaults. History offers little support to the idea, but the Fed seems willing to offer at least a little help. It may not be quite the world’s central bank, but the Fed is responding to turmoil in emerging markets much earlier than usual. – Copyright The Financial Times Limited 2015
