On Wall Street, international bond traders are fond of saying that when the winds are strong even turkeys fly. By this they mean that when global financial conditions are favorable, even countries with bad economic and political fundamentals have little difficulty in borrowing at very low interest rates. By this saying they also mean that when the tide of favorable global financial conditions recedes, countries all too often find that their lack of attention to maintaining sound economic fundamentals in the good times leaves them very exposed to major economic reversals in the bad times.
As the Federal Reserve now begins unwinding its unprecedented quantitative easing program, one would think that it would be well served by being mindful of Wall Street’s turkey adage. For never before has global liquidity been as ample as it has been in the past few years. And never before have the countries that have allowed their economic policies to slip in the good times been so important to the global economy as they are today. "Never before has global liquidity been as ample as it has been in the past few years."
In assessing how strong an influence Fed policy has had on the global economy of late, it is well to record how aggressive US monetary policy has been. In the immediate aftermath of the Great Economic Recession, short-term US policy interest rates were quickly reduced to their zero bound, while through forward guidance the Fed is now committed to maintaining those rates at this zero bound at least until 2015.
More importantly still, through successive rounds of quantitative easing, the Fed’s balance sheet has more than quadrupled in size to its present level of close to US$4 trillion. These policies have helped reduce US long-term interest rates to their lowest level in the post-war period and they have contributed to a very strong increase in US and global equity and housing market prices.
Since end-2008, the massive easing in monetary policy by the Fed, together with that by other major central banks, has resulted in substantial capital inflows into the emerging market economies. According to International Monetary Fund estimates, foreign portfolio investment in emerging market country bonds has risen by a cumulative $1.1 trillion through 2013. This has taken these inflows to levels substantially above their long-term trend.
Large capital inflows into the emerging market countries have resulted in a strong appreciation of those countries’ currencies, which has weakened those countries’ balance of payments positions. They have also compromised market discipline for the emerging markets by reducing their borrowing rates to levels well below those that would be justified by those countries’ economic fundamentals. In a number of notable cases, including Brazil, India, Indonesia, South Africa, and Turkey (the so called “Fragile Five”), easy global financing conditions have led to the postponement of much needed structural economic reforms and budget adjustment.
Perhaps of even greater concern for the global economic outlook is the present complacency of European policymakers concerning the European sovereign debt crisis. Fueling that complacency has been the considerable reduction in sovereign borrowing costs that has been occasioned by the unorthodox monetary policies of the world’s major central banks. Those lower borrowing costs have reduced the impetus for budget adjustment and structural reform in highly-indebted countries like Greece, Italy, Portugal, and Spain. They have also reduced Europe’s momentum towards either a banking union or a fiscal union that would appear to be so necessary for the Euro’s long-run survival.
An indication of the downside risks to the global economy that could be posed by an unwinding of US quantitative easing was provided by the sharp sell-off in emerging market assets in the aftermath of Fed Chairman Ben Bernanke’s May 2013 intimation that the Fed might begin tapering its quantitative easing program. In the six months following that intimation, the currencies and bonds of those emerging market countries that had experienced high rates of credit expansion and that had wide external current account deficits, came under considerable market pressure. And that pressure has considerably clouded their economic growth outlook.
"The key challenge for the Federal Reserve will now be to find the right balance in the pace at which it exits quantitative easing." In determining the pace at which it unwinds its quantitative easing program in the months immediately ahead, the Federal Reserve will need to be very mindful of the international spillovers of its exit policy. This would particularly appear to be the case given the large impact that the massive expansion of its balance sheet has had on the economic fundamentals of a number of key emerging market economies and on those countries in the European economic periphery.
The key challenge for the Federal Reserve will now be to find the right balance in the pace at which it exits quantitative easing. Too slow a pace of exit could further contribute to the undermining of market discipline in the emerging market economies and in the Euro-zone that would further build up economic imbalances. At the same time, too fast a pace of exit runs the risk of a sudden-stop in capital flows to the emerging market economies and Europe. And such an eventuality could prove to be disruptive both to the United States and to the rest of the global economy by up-ending an increasingly important part of the world economy.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.