On Wednesday, Lagarde said world leaders should fix global trading systems instead of tearing them down, in response to nationalist politicians pushing tariffs and protectionism. (Reuters)
Emerging markets have been left reeling as the possibility of an end to the era of easy money hits home.
The end to “unconventional monetary policy” in developed nations — notably the potential deceleration of quantitative easing in the United States — prompted Christine Lagarde, head of the International Monetary Fund, to wave warning flags at an annual economic symposium held in the US, last week.
She appealed to financial policymakers to be cautious about how they manage the process of unwinding the days of exceptionally loose monetary policy.
“The fund and policymakers need to start thinking about what exit will eventually look like. That includes the implications for global economic and financial stability — the whole system, not just one part of it,” she said in her speech.
For emerging economies, the effects are already being felt as markets begin to factor in the end to years of additional liquidity.
In her speech Lagarde noted that “by one measure, cumulative net flows to emerging markets rose by $1.1-trillion since 2008, squarely above its long-run structural trend by an estimated $470-billion”.
Quantitative easing
Quantitative easing is the purchasing by a central bank of assets such as government and other securities. It injects financial institutions with money in a bid to increase liquidity and help support economic recovery.
The end to this era of excess capital flowing into emerging market economies is not unexpected, as many economists have noted, nor will the process be immediate.
Nevertheless, the volatility of these capital flows and subsequent declines of emerging market currencies such as Brazil’s real, India’s rupee and South Africa’s rand hint at some painful re-adjustment to come.
All three currencies have weakened rapidly against the dollar in the last year. The rand declined to just over R10.40 to the dollar this week.
The threat of military action in crisis-torn Syria added to emerging market woes this week, pushing fuel prices to over $114 a barrel.
The ongoing volatility has caused consternation among local authorities. Finance Minister Pravin Gordhan told the Financial Times earlier this week that there is an “inability to find coherent and cohesive responses across the globe to ensure that we reduce the volatility in currencies in particular, but also in sentiment”.
Sentiment is key
Sentiment is key, as Nedbank economist Dennis Dykes pointed out.
Much of the market reaction was a “bit premature”, he noted, given that the US Federal Reserve had indicated that any tapering will be driven by improved economic performance in the US, and it would begin slowing its asset purchase programme rather than suddenly halting it.
He referred to the metaphor used by Federal Reserve chairperson Ben Bernanke, who likened tapering to lifting the foot slightly off the accelerator of a moving vehicle, rather than hitting the brakes. Nevertheless, market activity was more often driven by “expectation than reality” Dykes said.
Many emerging markets, including South Africa, had benefited from these policies through steady capital inflows into their bond markets and reduced borrowing costs, Dykes said.
In South Africa government bond yields have remained relatively low, averaging 7.3% last year. They have steadily increased in recent months, with yields skating closer to 8.5%. “We’ve had much lower borrowing costs that we have arguably merited,” said Dykes.
In addition, South Africa is running a budget deficit as well as a large current account deficit. The budget deficit was 5.2% of gross domestic product (GDP) this year, while the current account deficit was 5.8% of GDP in the first quarter.
Relying on foreign capital flows
South Africa has relied on foreign capital flows to sustain these gaps.
In the budget review earlier this year, the treasury noted that these funds have helped to finance infrastructure investments and keep borrowing costs “at historic lows”.
It noted that the funding costs on long-term fixed-rate bonds had fallen by an average of 2.34 percentage points since 2010. It was also keenly aware of “the risks associated with increased investment from overseas, including currency volatility and the potential for rapid withdrawal of capital”.
South Africa in no way faces all-out capital flight, but Investec economist Annabel Bishop said in a recent research note that foreigners, “who own a third of South African bonds and a third of its equities, have been less interested in purchasing these assets since the start of the year”.
The extent of market volatility has caught many by surprise, noted Sean McCalgan, a market analyst at macro strategy specialists ETM Analytics.
Generally, US banks expected that the Federal Reserve would reduce asset purchases by only $10-billion, but even that has been enough to spark this “blow-out”, he noted.
Government’s financing
The implication for government’s financing was not encouraging, he said. In terms of bond yields, South Africa “could be left vulnerable”.
The national treasury has a history of being “too optimistic” in its forecasts, he noted, and has had to reduce these in the past.
The government’s estimated borrowing costs could rise at the same time, as we are seeing an increase in the cost of debt, he noted.
The added pressure on government finances comes after Gordhan warned of very limited fiscal space during the budget this year.
The emerging market upheaval comes against a backdrop of rather lacklustre growth locally, as well as rising inflation thanks to the weakening currency.
Statistics South Africa revealed this week that GDP growth improved this quarter, from growth of 0.9% in the first quarter to 3%.
Improvement
The improvement was however off a low base, Nedbank said, and is unlikely to continue into the third quarter.
Dykes said that it was not all bad news and government had shown prudent financial management.
There were still measures South Africa could introduce to improve its competitiveness and alleviate the internal factors contributing to lagging domestic performance, he said.
These included returning policy certainty to the mining sector, as well as increasing electricity supply.
Private sector involvement in the building of a third coal-fired power station would take some strain off the government’s balance sheet and encourage private investment if business could be assured there would be increased electricity supply.