Who's afraid of the Grim Taper?

When the US Federal Reserve board’s Open Market Committee first started considering its exit from the Fed’s quantitative easing program, it was apparent that some members had concerns about the program’s unintended consequences. Now that the Fed has begun to taper its bond and mortgage purchases, those consequences are becoming ever more apparent and disconcerting.

Last night’s sell-off in equity markets was ostensibly triggered by weak US manufacturing data, with some contribution from similarly weak purchasing managers’ numbers in China. It came against a backdrop of increasing turmoil in emerging market economies and rising concerns about the flow-on effects for the developed world.

Five years of effectively zero interest rates and money-printing in the US and similarly expansive monetary policy in Europe and Japan may have averted something akin to a depression in the aftermath of the financial crisis. However, it has so badly distorted capital flows, pushing them into risky asset classes in search of positive returns.

The post-crisis period has been characterised by bouts of extreme financial market volatility, as investors’ mindsets have switched from ‘risk-on’ to ‘risk-off’. But until the Fed began its taper in December by reducing its $US85 billion bonds and mortgages purchases by $US10 billion a month (following up with another $US10 billion reduction this month), the capital flows were more tactical than strategic.

That now appears to have changed. There is an exodus occurring from emerging market economies, with capital pouring out of countries like Argentina, Brazil, Russia, Turkey, India, South Africa and the Asian economies on a scale last seen during the 1997 Asian financial crisis.

Developing economy central banks have responded by pushing up interest rates. So far they are failing to slow the exodus of capital or currency depreciations while depressing activity within their own economies.

The Fed’s taper and the rush of capital for the exits has exposed the vulnerabilities in those economies that was partly created by the massive inflows of cheap capital during the ‘risk-on’ periods.

It has also underscored how the extraordinary growth in exchange traded funds has exacerbated volatility in financial markets, with flow-on effects to real economies. In the space of a decade or so, the ETFs have become a major conduit for investment in commodities and emerging markets.

Morgan Stanley has estimated that ETFs now account for nearly a quarter of the investment in emerging market equities. It is the ETFs that have led the scramble to quit those markets in the past couple of months.

The emerging market turmoil, coupled with the question mark over the outlook for China, isn’t good news for the developed world. It has been reliant on China (and, to a lesser degree, the developing economies) to provide modest levels of global growth.

The expansionary monetary policies of developed economies have also had domestic impacts, pushing up share prices and pushing down bond yields.

Last night in the US, there was a sell-off in equity markets and a tide of money flowed into US bonds. Over-inflated equity markets could be regarded as another of the ‘bubbles’, which were the unintended consequence of five years of unconventional monetary policies in the developed world.

The instability in markets and economies comes at a particularly sensitive time for the eurozone, which has been showing some weak indicators of recovery.

In November, the European Central Bank takes over responsibility for supervising the eurozone’s banks in what the Europeans regard as a key post-crisis reform. In preparation for that takeover, the ECB plans a rigorous series of stress tests of the banks.

European banks are the biggest developed world lenders to emerging markets, with trillions of dollars of exposures.

Given there is an expectation that the ECB tests will reveal a substantial shortfall in eurozone banks’ capital adequacy – there are some estimates around the $150 billion mark but it wouldn’t surprise if the banks needed to raise significantly more than that – the last thing the Eurozone needs is another emerging markets financial and economic crisis. This would generate more bad and doubtful debts for already vulnerable balance sheets, and will require even more capital to meet the ECB’s capital adequacy requirements.

Given the opacity of capital flows in the post-crisis period, there was always going to be some uncertainty and volatility associated with even a gradual withdrawal/ tapering of the Fed’s massive injections of liquidity into bond and mortgage markets.

The early flow-on effects are disturbing and somewhat threatening – and not just for the developing world.