Taper Tantrum Redux?
April 29, 2022
How well are emerging markets prepared for the Fed tightening cycle in 2022? Or will they be vulnerable to significant disruptions like in 2013?
On May 22, 2013, the then Fed Chief Ben Bernanke appeared before the Joint Economic Committee of the US Congress and indicated the possibility of scaling back the asset purchases program (QE3) launched in response to the 2008 global financial crisis. Investors panicked, bond yields shot up and stock prices crashed. With the Fed chief’s one statement, investors dumped EM financial assets en masse and moved their capital to safe-haven assets in developed markets, a behavior that was christened the “taper tantrum.” This led to a massive reversal of capital flows from Asian and Latin American EMs leading to significant depreciation of currency.
In particular, the turbulence was felt most in the “fragile five” emerging market economies (EMs) – South Africa, Brazil, India, Indonesia, and Turkey. A high current account deficit and dependence of foreign capital made them ‘fragile’ and caused capital flight.
Cut to 2021, the current Fed Chair Jerome Powell indicated that the Quantitative Easings (QE) that kicked off with the pandemic resulting in the purchase of around $ 120 Billion of bonds and securities since March 18, 2020 will be unwound starting March ’22. Although the Fed was at pains to not link the QE tapering with the interest rate hikes, the reality is that the latter rose in tandem. On April 21, Powell announced that a hike of 50 basis points “will be on the table” in May.
However, this time around, it is expected that the Taper tantrum of 2013 may not repeat itself, except in case of a few countries. Here is why:
- Most markets have already factored in the Fed taper: The erstwhile fragile-five have undertaken major monetary and fiscal measures to dampen the impact of the taper. This includes increasing the forex reserves, monetary tightening which was already under way due to Covid and actions by central banks to defend their currencies.
- While Inflation in the US is at a 40-year high, most analysts believe it may peak by the mid-2022, as there are already signs that the core inflation, expected to rise by 0.5% for March actually grew by only 0.3%.
- While Inflation is a concern in EMs, the Asian markets are viewing it more as a transitory phenomenon as global supply chain disruptions steadily ease and the pressure on margins concomitantly taper off. On the other hand, the European markets continue to remain vulnerable due to the geo-political turmoil in the region and the resultant uncertainty could have a ripple effect on their economies. For instance, Turkey could face some headwinds, both due to the increasing inflation domestically accentuated by the fact that imports food grain and oil. The Central banks of Brazil, Chile and Mexico have responded with a rate hike.
- The no-surprise scenario: Both the Fed and the European central bankers have taken great pains to avoid any knee-jerk reaction to statements and actions. While Powell announced his plans in August 2021 on the winding down, he gave enough time for the global economies by setting a time frame starting March 2022.
However, there are exceptions.
For instance, economies having a high external debt could face a severe impact from the tapering. This is also true of countries with a high degree of dollarized banking system. Examples include South America and Africa. While the former have high exposure to foreign sovereign debt, the economies of the latter are heavily dollarized.
As against the ‘fragile 5’ in 2013, this time around there seems to be a ‘fragile fifteen’ to contend with. These are Sri Lanka, Indonesia, the Philippines, Bahrain, Egypt, South Africa, Tunisia, Zambia, Angola, Hungary, Turkey, Brazil, Colombia, Chile and Jamaica.
These 15 EMs are experiencing economic difficulties due to a combination of factors, including weak domestic currencies, low forex reserves, high foreign currency debt levels, significant foreign ownership of domestic financial assets all of which is leading to a sharp fiscal deterioration, rising inflation and weak growth prospects.
Latin American economies such as Argentina, Ecuador, and Belize and others such as Lebanon, Suriname, Zambia – have already defaulted on their sovereign debt. Sri Lanka is in deep distress due to debt default as well as completely non-existent forex reserves. There could be more debt defaults in the coming months across a dozen countries including Egypt and South Africa as existing debts may become difficult to refinance, leading to defaults.
Dollarization of the economies will accentuate the problem. According to data compiled by Moody’s Investors Service, close to 90% of bank deposits and loans are denominated in the US dollar in the Democratic Republic of the Congo, 42% in Angola and more than 30% in Tanzania, Uganda and Namibia. Approximately 25% of the banking system in Nigeria, Ghana, and Egypt is dollarized.
The weakening of domestic currencies would further complicate the debt sustainability of EM debt levels because currency depreciation would automatically push up the cost of external debt.
However, the imponderable continues to be to be oil prices and its spiralling effect on the fragile economies. Coupled with the impact of Covid and an uncertain geo-political situation, the tapering will severely affect the already-vulnerable economies while leaving others largely unscathed. The affected economies will have to deal with economic, political and social unrest, as the case of Sri Lanka and it will take IMF and several years before these countries are able to see a modicum of stability.