TWN Info Service on Finance and Development (Sept13/04)
23 September 2013
Third World Network
 
Market-led tightening causes tremors in emerging economies
Published in SUNS #7656 dated 18 September 2013
 
Geneva, 17 Sep (Kanaga Raja) -- Announcements in May that the US Federal Reserve envisaged phasing out quantitative easing reverberated through global financial markets, triggering "a surge in benchmark bond yields that spilled over across asset classes and regions," the Basel-based Bank for International Settlements (BIS) has said.
 
In its latest Quarterly Review of September 2013, BIS said that equities in both advanced and emerging market economies registered abrupt and sizeable losses during this episode. In addition, investor retrenchment from emerging economies led to steep depreciations of a number of local currencies.
 
According to the BIS report, the sell-off abated in early July when the Federal Reserve, the European Central Bank (ECB) and the Bank of England reassured markets that monetary policy would remain accommodative until the domestic recovery was on a solid footing.
 
"As the rise in long-term interest rates continued, however, markets effectively precipitated a tightening of financial conditions worldwide."
 
BIS noted that the policy announcements occurred after a prolonged period of exceptional monetary accommodation in advanced economies, just as the economic outlook there was turning positive. They caught markets by surprise, reminding them that negative term premia cannot last indefinitely. Even though this resulted in temporarily higher market volatility, equities eventually recovered from the losses incurred during the sell-off.
 
Furthermore, despite their rise, yields remained low by historical standards, thus perpetuating the relative appeal of higher-yielding asset classes. This extended the squeeze of credit spreads and fuelled strong issuance of bonds and loans in the riskier part of the spectrum, a phenomenon reminiscent of the exuberance prior to the global financial crisis.
 
"The market-led tightening of financial conditions generated serious tremors in emerging market economies, which had been in a soft spot. The outlook for these economies was deteriorating, as imbalances inherited from a period of rapid credit and GDP growth were unwinding."
 
According to BIS, "the imported tightening thus amplified pressures on local markets and brought to the fore the vulnerability of countries dependent on fickle foreign capital. In the face of additional strong headwinds from escalating geopolitical tensions, the downward pressure on currency and equity values persisted in a number of emerging economies even after the sell-off had abated in advanced economies."
 
According to the Quarterly Review, market participants started pricing in the end of quantitative easing on 3 May, when upbeat news on employment confirmed the positive outlook for the US economy. This led to a bond market sell-off that set US Treasury yields on an upward path and effectively brought monetary tightening forward in time. And even though higher policy rates remained a fairly distant prospect, volatility picked up and trading in the Treasury market reached record volumes owing to conflicting views on when and how various monetary policy instruments would be phased out.
 
The US bond market sell-off reverberated globally, affecting a broad range of asset classes in both advanced and emerging market economies, said BIS, citing as example that the yields on European long-term sovereign bonds also started their ascent on 3 May and the corresponding Japanese yields edged up.
 
"Mortgage-backed securities promptly followed suit, as less attractive refinancing prospects lengthened the duration of these instruments, thus increasing their interest rate sensitivity. At the same time, the rising yields in advanced economies set in motion a sustained depreciation of major emerging market currencies with respect to the US dollar."
 
The markets for high-yield bonds and equities joined the sell-off with a three-week lag. This happened after 22 May, when the Federal Reserve Chairman stated that the Federal Open Market Committee could envisage reducing the pace of asset purchases to ensure that the stance of monetary policy remained appropriate as the outlook for the labour market or inflation changed. On this statement, high-yield indices started cheapening markedly in advanced economies on both sides of the Atlantic, as well as in emerging market economies.
 
At the same time, said BIS, a half-year rally in advanced economies' equity indices came to an end amid elevated volatility, as market players, scathed by years of sub-par returns, reassessed a rapidly evolving financial landscape. And following their lacklustre performance earlier on, emerging market equity indices plummeted.
 
Then, global markets evolved largely in sync until 19 June, when the Federal Reserve Chairman emphasised that the envisaged slowdown of asset purchases should be consistent with the unemployment rate decreasing to 7% by mid-2014. As an immediate response, market volatility and bond yields edged further up, and equity prices dropped abruptly.
 
"Within a week, however, the bearish mood in equity markets subsided, sending major indices on an upward path. Likewise, there soon was a distinct reduction in the upward pressure on US and emerging market corporate bond spreads, as well as on euro zone sovereign yields."
 
By contrast, BIS noted, the sell-off on the US Treasury and the euro area corporate bond markets continued until early July, when major central banks joined forces to reassure markets that the monetary stance would remain supportive on the path to recovery.
 
To alleviate the market-induced tightening of funding conditions, central banks on both sides of the Atlantic issued forward guidance as regards the future path of monetary policy. The Federal Reserve had emphasised for some time the continuation of its low interest policy as long as macroeconomic conditions warranted it. On 4 July, the Bank of England and the ECB also took steps towards forward guidance by stating explicitly that rising bond yields were not in line with monetary policy intentions and fundamentals.
 
By the time central banks' forward guidance finally halted the two-month-long gyrations in global markets, bond yields as well as equity and currency valuations had evolved substantially, said the report, highlighting that between 3 May and 5 July, the yield on the 10-year US Treasury note increased by 100 basis points, to 2.74%, and that in addition, the May and June increases in the 10-year sovereign yields of Japan, Germany and the United Kingdom amounted to roughly 30, 50 and 75 basis points respectively.
 
By contrast, mature equity markets went through swings without clear direction, with the EURO STOXX 50 and FTSE 100 registering 6% and 2% losses, and the Nikkei and the S&P 500 gaining 4.5% and 1%, respectively.
 
In emerging market economies, BIS underlined, the concurrent losses were much larger. For instance, the yield on the composite emerging market high-yield index rose by 130 basis points and the equity indices of the BRIC (Brazil, Russia, India and China) economies lost 3-13% of their local currency values between 3 May and 5 July.
 
Over the same period, the currencies of Brazil, India and Russia depreciated by roughly 10% with respect to the US dollar. Likewise, the yields on the latter two countries' US dollar-denominated bond indices rose by more than 100 basis points, outstripping the rise in yields on local currency bonds.
 
According to BIS, the announcements about the future path of US monetary policy occurred against an improving growth outlook in advanced economies, which stood in sharp contrast to the slowdown in emerging market economies.
 
The US recovery proceeded at a moderate pace, even as unemployment was expected to decline only slowly. At the same time, upward revisions in growth neutralised any remaining fears of a triple-dip recession in the United Kingdom. In turn, the euro area emerged from a six-quarter contraction, with Germany and France pushing area-wide growth to a modest but positive 0.3% in the second quarter, a growth rate that was expected to weaken only slightly in the third quarter and then persist over the following year.
 
In addition, market participants drew confidence from manufacturing PMI indices in the second and third quarters, pointing to expansion in most advanced economies. On the other hand, PMI indices in emerging market economies generally deteriorated. Moreover, the balance of economic surprises in major advanced economies moved into positive territory for the first time since March but remained negative in emerging markets.
 
"It was the interplay between improving economic outlooks and anticipated changes to the monetary policy stance that shaped the recent behaviour of bond markets in advanced economies. The two drivers reinforced each other in raising the term premia embedded in bond prices. Even though credit spreads rose as a result, they remained below the levels seen in 2012, reflecting an ongoing search for yield."
 
The report said that an examination of the rise in US bond yields between May and July reveals as a key driver the uncertainty about the future stance of monetary policy. The sell-off mainly shifted bond yields at long maturities, while the short end of the yield curve remained anchored by the Federal Reserve's continued low interest rate policy. In addition, the federal funds futures curve also shifted upwards, signalling market perceptions that a policy rate exit from the current 0-0.25% band had become quite likely to occur as early as in the second quarter of 2014.
 
A model-based decomposition of the 10-year US Treasury yield, which sheds light on the various drivers of these shifts, indicates that the recent yield spike was largely the result of a rising term premium. This is consistent with markets reacting to uncertainty about the extent to which an improving economic outlook would affect future policy rates. It is also consistent with uncertainty as regards the impact that a reduction in the Federal Reserve's purchases of long-term Treasuries would have on these securities' prices.
 
In comparison, added BIS, the bond market sell-offs in 1994 and 2003-04 were different in nature. During those episodes, long-term nominal yields rose together with policy rates or on the back of expected increases in future real interest rates and inflation. By contrast, inflation expectations were largely unchanged in the second and third quarters of 2013.
 
"The recent sell-off did little to undermine the relative appeal of riskier securities, which asserted itself in the second half of 2012 and persisted through the third quarter of 2013," BIS noted, adding that the attractiveness of riskier securities surfaced as a persistent squeeze of credit spreads.
 
The bond market sell-off in May and June reversed this process, but only temporarily in advanced economies. After their peak at mid-2012, credit spreads in these economies plummeted by more than 30% to reach roughly 350 basis points by early September 2013. Thus, while still well above their pre-crisis trough in 2006, they reached levels last seen at end-2007.
 
Recent debt issuance also reflected investors' interest in the riskier part of the credit spectrum. For instance, the high-yield share of aggregate bond issuance by European firms exceeded 15% in the first quarter of 2013, up from roughly 12.5% in 2012. In addition, banks increasingly funded themselves with subordinated debt, much of which was expected to be of sufficient loss absorbency to count towards regulatory capital. Compared with the 12 months to mid-2012, the issuance of subordinated debt increased almost tenfold in the United States and 3.5 times in Europe to reach roughly $22 billion and $52 billion respectively over the 12 months to mid-2013.
 
A trend favouring riskier lending was also evident in the syndicated loans market. A concrete manifestation was the growing popularity of "leveraged" loans, which are extended to low-rated, highly leveraged borrowers paying spreads above a certain threshold. The share of these loans in total new signings reached 45% by mid-2013, 30 percentage points above the trough during the crisis and 10 percentage points above the pre-crisis peak.
 
"The summer months of 2013 confirmed a reduction of the brisk growth in key emerging market economies and a clear deterioration in their outlooks," said BIS, adding that for some of these economies, the slowdown had deepened with the decline in the prices of certain commodities - notably, industrial and precious metals - after mid-2012.
 
In addition, part of the slowdown was engineered by policymakers, which had been leaning against financial imbalances. For instance, a number of Latin American countries had implemented policies to limit the inflow of foreign capital, including taxes on foreigners investing in certain financial instruments.
 
Meanwhile, Chinese authorities had taken steps to rein in credit expansion. Combined with a reduction in US dollar inflows, this policy initiative culminated in a liquidity squeeze in the local interbank market in June. Even though August data releases surprised on the upside, previous below-expectation figures on China's growth had negative repercussions on other emerging markets. For instance, this translated into a substantial drop in the foreign demand faced by commodity exporters, such as Brazil and Russia.
 
Against this background, BIS emphasised, the improved growth prospects in advanced economies and the tightening of global financial conditions contributed to investors' retrenchment from emerging market economies. This resulted in sustained declines in the value of local assets. For example, while equities in advanced economies had largely recovered their June losses by end-August, a broad emerging market equity index continued to linger around 12% lower than in early May, close to levels last seen at mid-2012. A similar pattern was also visible in flows into and out of bond market funds.
 
"Investors were quick to retreat from such funds worldwide in June, but while the flows promptly reversed and stabilised for advanced economies, investors continued to pull money out of emerging market funds. And the resulting cumulative outflows from June to August amounted to the cumulative inflows over the previous five months."
 
According to BIS, the investor retrenchment occurred on the back of mixed indicators of financial vulnerability in emerging market economies. Indeed, these economies' external debt and capital inflows were most recently lower as a share of GDP than before 2008.
 
That said, many emerging economies had built up financial imbalances in the wake of rapidly expanding private borrowing. For instance, issuance of emerging market corporate bonds had gathered speed, as yields on such bonds had fallen to unusually low levels. And the negative side effects of rising indebtedness included growing signs of deteriorating lending standards in the banking sector, as indicated by rising volumes of non-performing loans.
 
"Thus, given perceptions that the valuation of emerging market assets had been inflated by ample liquidity conditions in past years, investors rapidly shifted out of these assets as rising yields in advanced economies signalled the beginning of the end of easy credit."
 
Following a broad-based depreciation of emerging market currencies vis-a-vis the US dollar, investors refocused on the fundamentals of individual countries. As a sign of the transition, the co-movement of depreciation rates, which had been quite strong in June and July, declined to levels seen earlier in the year. In particular, investors zeroed in on countries with large current account deficits that are especially vulnerable to sudden capital outflows. Indeed, countries with high deficits, such as Brazil, India, Indonesia, South Africa and Turkey, experienced the sharpest currency depreciations.
 
As the negative outlook for India was reinforced by reports of rising bad loans at local banks, the rupee fell to an all-time low vis-a-vis the US dollar in late August. In Brazil, reports that the current account deficit was widening faster than expected - to $9 billion in July - added to downward pressures on the real stemming from political uncertainty. Similarly, Indonesia's rupiah fell on new data showing that the country's current account deficit had widened from 2.6% of GDP in the first quarter of the year to 4.4% in the second.
 
Meanwhile, BIS noted, a number of central and eastern European countries benefited, as investors perceived them to be relative safe havens among emerging market economies. This was due to these countries' better current account balances, as well as their greater reliance on exports to the euro area, which had shown signs of recovery.
 
In a number of countries with high current account deficits, high domestic inflation exacerbated the situation, BIS further said, adding that at end-August, year-on-year WPI inflation in India was close to 6% and CPI inflation in Indonesia and Turkey was above 8%, partly because of significant currency depreciations that had raised import costs. And high rates of inflation may in turn lead to additional nominal depreciation, thereby fuelling a vicious circle.
 
With emerging market authorities facing challenges on several fronts, their main policy responses aimed at curbing the depreciation of domestic currencies. In the face of rapidly declining investor confidence, the Reserve Bank of India intervened to put upward pressure on money market interest rates and imposed capital controls.
 
By late August, however, there were few signs that this had slowed the pace of the rupee's depreciation. Indian officials also announced longer-term measures to contain the current account deficit, including taxes on silver and gold imports and steps to liberalise iron ore exports and to reduce India's dependence on imported coal.
 
"Likewise, the Indonesian, Turkish and Brazilian central banks raised policy rates and intervened in foreign exchange markets in an attempt to reduce the outflow of foreign capital and stabilise the domestic currencies. The sizeable foreign exchange interventions of several central banks contributed to significant reductions in official foreign reserves over the past few months," said BIS.
 
[In a post on 12 September at his blog on the New York Times, Nobel Laureate Paul Krugman has accused the ‘international technocrats' at the EU Commission, the BIS and the OECD of playing a remarkably destructive role in the face of high unemployment and low inflation, in consistently calling for policies that would depress advanced economies even more. He has charged that such advice has come, not from a rigid application of conventional economic models, but "making up stories on the fly" to advocate and justify "tightening both fiscal and monetary policy". And while the OECD has been the second worst offender, "the BIS gives it a run for the (tight) money". From back in 2010, "it was among the most eager pushers of fiscal austerity, even as it also called for a sharp rise in policy interest rates. That didn't happen, but the austerity did."- SUNS] +