This is the tale of a dragon; a dragon born at the heart of the 2008 financial crisis. He was born and he has been travelling the world, looking for a place to prosper. To understand the nature of the dragon we first need to understand US monetary policy, and this is where we start.
In November 2008, the Federal Reserve of the United States (FED) announced the first round [Figure 1] of massive purchase of assets – quantitative easing – with the purpose of increasing the liquidity in the financial system to push banks into lending to the real economy.
A conventional measure to increase liquidity, such as reducing the federal funds rate, was no longer available, as the short term interest rate was already at the zero lower bound [Figure 2]. The third round of the unconventional measure ended in October 2014.
This marks the beginning of the journey of our dragon. The economic scenario “pushed” investors out of the US economy, by turning the latter into a less desirable setting for investors pursuing high yields. As a result, emerging markets were brought to the main stage. For these emerging economies, this meant an increase in the amount of capital inflows, as can be seen in [Figure 3].
The flow of capital is not homogenous across countries and this can be explained by the different institutional and macroeconomic fundamentals (pull factors) of each country.
You might be wondering in what countries our dragon ended up living. The headlines mention the famous Morgan and Stanleys’s “fragile five” (Brazil, Indonesia, India, Turkey, South Africa) and also countries such as Poland, Hungary and Chile.
Theoretically, in the absence of further shocks, a country that experiences a substantial increase of capital inflows tends to overheat its own economy, i.e., a high rate of economic growth [Figure 4] usually associated with an inflationary spiral [Figure 5]. Additionally, the current account [Figure 6] of the country is expected to deteriorate due to an increase in the purchase of domestic assets by foreign investors. This might lead to an appreciation of the domestic currency.
This economic setting was the new home for the dragon. And, while living in this overheated economy he was mildly happy, almost always sleeping, as no one ever bothered to explore the effects of having him in their country.
Hosting a dragon while he is being well fed, it’s not a problem, however if something hints that the food for the dragon might end, suddenly all you see is fire. This was what happened when Ben Bernanke hinted in May of 2013 the unexpected possibility of decreasing the pace of the quantitative easing – “taper talk”, Figure 7. As a result, investors started to retrieve their money from the emerging markets – the dragon left, but left everything in flames behind him.
Doing a data analysis of the effects on the real economy after the taper talks, taper start and ending of the third round of the quantitative easing does not provide us with the full length of the effects of the capital outflows. However, the actions taken by the different governments that suffered this flight of capital i) shed important light on the implications that could be felt in the economies and ii) will have a great impact on future economic scenario, mainly in balance of payments and potential domestic financial crisis.
In terms of the benchmark interest rate settled by Central Banks we can observe different patterns happening in the aftermath of the May 2013 announcement. For Brazil, Turkey, South Africa and Indonesia, there is a path to increase the rate in order to make it attractive for investors. India reacted fast by increasing the rate, however stabilizing it in January 2014 at a lower level than the jump in May 2013. Poland and Hungary, two countries in the European Union did not act in a manner to attract investors as they kept decreasing their benchmark rate (mainly due to concerns in entering the Eurozone). The impact that each of these monetary policies can have on future economic growth is an issue to be taken into consideration, but we cannot yet evaluate the effects.
However, the only challenge is not just a restructuring of domestic economies. Dragons do like to fly, and this time it seems eminent that an European dragon is about to spread his wings. Can Emerging Markets host a new dragon? Will they pay more attention to him this time?
Alexandre Silva, 630
Matilde Grácio, 684