Saturday, 1 February 2014

Stop Preaching Emerging Countries, Blame Ben and VIX®

End January, emerging-market turmoil from India to Brazil and Turkey spread across global markets amid a selloff in developing-country currencies and growing concern over China’s economy. The Chicago Board Options Exchange Emerging Markets ETF Volatility Index rose 40 percent to 28.26 last week, the biggest increase since September 2011. The devaluation of Argentina’s peso, data signaling a possible contraction in China’s factory output and declines from the Turkish lira to the South African rand shook investor confidence. Emerging-market equities have tumbled since the Federal Reserve signaled in May 2013 that it could start scaling back bond purchases that boosted demand for higher-yielding assets.

Many central bankers reacted early 2014 by hiking interest rates (rather than let their currencies float or impose capital controls as Malaysia did in 1998); that policy response is sure to translate financial turmoil into real-economy slump this year and will thus probably be self-defeating (remember 2nd generation models?). Hiking interest rates will deepen a recession where lost external competitiveness would require currency depreciation; instead, the resulting strong interest rate differentials with the developed world will soon reignite profitable carry trades and appreciating currencies. A vicious cycle that can only be broken by the very capital controls that the US Treasury (seconded by US-led institutions such as the OECD) has talked emerging countries into dismantling.

As usual, the blame is on the losers. Dani Rodrik and Arvind Subramanian, in a maliciously tilted op-ed “Emerging Markets´ Victimhood Narrative”, are perhaps the most appalling example so far: “Emerging markets aren’t hapless and undeserved victims; for the most part they are simply reaping what they sowed.” They indeed seem to think that the Fed has rescued the world economy with its ultra-loose policy. No empathy then for central bankers – notably Brazil´s – who always complain: When the Fed relaxed via quantitative easing and as a result money flew into emerging markets and currencies got overvalued; and when the Fed slowly starts to unwind (taper) that capital is fleeing.

Rodrik and Subramanian seem to think that this is actually a logical argument. It is not. Excesses in poor countries – consider their relative small asset base to the huge assets built up in ageing developed-country portfolios - can go both ways, the ultimate cause is still excessive money supply by the Fed. More than thirty years of asymmetric monetary policy in the US, Japan and more recently Europe have driven nominal money markets rates toward the zero bound and real rates below. Ultralight money has created asset bubbles migrating from real estate to classic cars and emerging markets and much more: Increasingly frequent financial crises were the result and accommodated by lower interest rates and higher money supply; upswings did not witness a symmetric tightening of monetary conditions[1].

Mean money market rates in the US, Japan and Eurozone
Working Papers 121, University of Leipzig.

The effects of asymmetric monetary policy might be attenuated by symmetric monetary cooperation in the BIS or the G20. And indeed, Raghuram Rajan, India´s central bank governor (former Chicago U professor and IMF chief economist) just complained about asymmetric cooperation[2]: “International monetary co-operation has broken down. Industrial countries have to play a part in restoring that [co-operation], and they can’t at this point wash their hands off and say, we’ll do what we need to and you do the adjustment.” Without mentioning his name, Rodrik and Subramanian counter Rajan´s quest with a truly obnoxious assertion: “The problem with this nonreciprocal argument is, simply, that the stimulus enacted in 2008 and 2009 was entirely self-interested. The Fed may not be internalizing the objectives and constraints of other countries today, but neither did emerging markets act on the behalf of the Fed then. It isn’t convincing to cloak self-interest as unselfish cooperation.” As if the Reserve Bank of India was the world´s lender of last resort and its money supply carried the same strong cross-border externalities that Fed policy has. At least here it is clear to the reader: The Rodrik-Subramanian article aims at distracting from US responsability.

Like we discovered in the Euro crisis, morality driven blame games crowd out serious economic analysis; especially, when the incidents result from system immanent failures such as the workings of a monetary union with divergent countries[3]. So please do stop preaching emerging countries! In her influential Jackson Hole 2013 lecture, Hélène Rey[4] has convincingly shown that the crucial determinant of the global financial boom-bust cycle is monetary policy in the US, which affects leverage of global banks, credit flows and credit growth in the international financial system. The close link between the US monetary stance, the CBOE Volatility Index VIX®, investors´ risk appetite and debt flows has been observed for a while now. This channel invalidates the “trilemma”, which had postulated that in a world of free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. Rather, cross‐border flows and leverage of global institutions transmit monetary conditions globally, even under floating exchange‐rate regimes. Emerging countries, whatever their exchange rate regime and even their macroeconomic policies, are natural victims with their narrow asset bases relative to investor portfolios.

[1] Andreas Hoffmann & Gunther Schnabl (2011), "A Vicious Cycle of Manias, Crises and Asymmetric Policy Responses – An Overinvestment View," The World Economy, vol. 34(3), pages 382-403, 03.
[2] Financial Times, “ India´s Raghuram Rajan hits out at unco-ordinated global policy”, 30th January 2014.
[3] See my „Rudi Dornbusch, the Euro and the Latin Triangle”, ShiftingWealth Blog, 7 June 2012.


  1. "Blaming the victim" may be encouraged by framing, as many authors do, trends in reference to GDP (even more so when PPP is being used). This makes emerging market economies look relatively large, and hence it is natural that they should be expected to mind their manners. However, when talking about financial crises, it is not GDP that matters so much as financial variables: in the case of short-term capital, liquid financial assets and liabilities. The ratio of convertible liquidity, however measured, in the money market centers (essentially US, London, EU) to those in Brazil, China, India, much less Turkey or South Africa is vastly higher than that of their respective GDPs. This is why, notwithstanding the impressive growth of "emerging economies", the money markets are still "the dog", emerging markets its tail, and the many smaller markets, the tip of the tail. When the dog sneezes, the tail shudders.

  2. Guy, I see how well you are informed about 'dogs'. I fully agree!