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Looming Large As Fed Poised to Rein in Quantitative Easing
Looming Large As Fed Poised to Rein in Quantitative Easing
  • By matthew
  • September 2, 2013, 08:12
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During the three years following the Fed’s earlier-than-expected interest rate hike in 1994, the bond rate rose in advanced countries and money drained out of emerging economies, leading to a financial crisis in some.

Similar things seem to be happening these days across the world. Confusion is building up surrounding the July FOMC minutes released on August 21 (local time). Foreign news outlets have taken the initiation of the Fed’s exit strategy before the end of this year as an established fact, yet opinions are split on whether it will be September or December. Experts are predicting that the US Treasury bond rate will continue to rise due to such controversies and that Asian economies will experience greater trouble.

After the release of the minutes, the 10-year Treasury yield reached its highest level, 2.89%, since July 2011. “The FRB is postponing its decision to affect emerging markets, the mortgage rate, and retirement pension, etc,” The New York Times reported.

Recently, investment funds have been returning from emerging economies to the US Treasury bond as the interest rate climbs. Countries whose dependence on foreign funds is particularly heavy, e.g. India and Turkey, are taking a direct hit. Under such circumstances, concerns are rising over the possibility that developing nations could repeat the 1997 Asian financial crisis. The currency depreciation rate has already reached 18% and 12% for the Brazilian real and Indian rupee, respectively. Meanwhile, growth forecasts are for Southeast Asian nations such as Indonesia and Thailand are also bleak.

Will the 1997 Asian Financial Crisis Repeat Itself?

Former Fed chairman Alan Greenspan hiked the 3% rate in February 1994 in an attempt to tamp down inflation from the get go before economic recovery. The key rate reached 6% in June 1995.

Forex market participants in emerging economies panicked as overseas investment funds from advanced countries began to be withdrawn. Eventually, Mexico received a bailout in 1994 and financial crises broke out across Asia three years later, with Korea also receiving a bailout package from the IMF.

The recent financial debacle in emerging nations shares the same thread in essence, although there might be some slight difference in the way the Fed withdraws excess liquidity. The massive funds invested since the 2000s in emerging countries are poised to flow out with the Fed signaling a reduction of quantitative easing. Since 2008, foreign liabilities have increased by 13.8% on annual average in Brazil and 13.1% in India. The total amounts to US$390 billion for India as of the end of March this year, which is far larger than its foreign exchange reserve of US$278 billion.

It is the capital outflow that has tumbled the Indian economy, something which had enjoyed an average 8% annual growth. Monthly foreign investment in India has been more than halved from US$5 billion to US$2.3 billion between September last year and May this year. “Foreign funds were attracted by the huge market of 1.2 billion consumers, but it seems that their patience has reached the limit,” the International Herald Tribune pointed out.

Economic Slowdown in China Adding Fuel to the Fire

China’s economic growth rate, which dipped below 7% annually, is another risk factor in that most emerging economies, including Brazil and Indonesia, export raw materials to China. Brazil, which ships 17% of its total exports to China, is suffering from a declining growth rate as China’s demand for iron ore and grain falls. Its economic growth rate has fallen from over 7% before 2010 to 2.7% in 2011 and 0.9% in 2012, and it is estimated at below 3% this year. The rate for Indonesia, which earns 60% of its GDP through the export of raw materials such as coal, palm oil and rubber, hit the lowest of 5.81% since March 2010 in the second quarter of this year.

The possibility of another crisis is increasing quickly, along with the current account deficits and external liabilities of such emerging economies. This has resulted in currency depreciation, further fueling disinvestment by foreign investors.

India, the Most Vulnerable

For now, India is regarded as the most vulnerable country because the majority of the others are maintaining fiscal surpluses, while India’s budget deficit-to-GDP ratio amounts to 5.6%. “Brazil and Indonesia are natural resource exporters, whereas India is a huge importer of energy resources, which means the latter is particularly susceptible to external risks,” The Financial Times said.

The Indian government recently announced that it would put a brake on overseas remittance in an attempt to block the currency value from dropping, but the depreciation is accelerating nonetheless due to the investor exodus. According to UBS, the exchange rate is likely to fall to 70 rupees per US dollar.

In the meantime, Brazil is considered to be out of the danger zone with its foreign exchange reserves standing at US$374.4 billion. However, the real economy remains stagnant despite an injection of approximately 300 billion real. Meanwhile, current account deficits are soaring in Indonesia. The red ink surged close to 70% to US9.8 billion between the first and second quarters of this year, while Thailand recorded consecutive negative growth during the two quarters and entering a depression for the first time in five years.

​What is the Impact on Korea?

Foreign exchange market participants in Seoul are concerned over the emergence of another financial crisis. They are closely watching the possible impact of the high currency volatility on the local forex market, with some dealers comparing the current situation to the 1997 Asian financial crisis.

“This year, emerging country currencies are being depreciated at a very rapid pace in Brazil, India and the like,” said one, adding, “It seems that the reduction of quantitative easing by the Fed is sending shockwaves through the entire financial markets of emerging economies.” He went on, “We can’t rule out the possibility that Korea could take a hit from the situation, although it has refined its fundamentals since the recent turmoil.”

Another dealer echoed this saying, “Things are quite similar to 1997 and 1998 in that the value of the currencies drops and the financial authorities of emerging nations are resorting to their forex reserves as a countermeasure,” adding, “Furthermore, both periods are similar in that a policy change on the part of the US is making developing countries restless.”