Back in January, I wrote that low yields on U.S. government bonds were pushing investment into emerging markets like Thailand and Indonesia, where more attractive returns could be had. (Indonesia’s benchmark rate is currently 3.5 percent, which is quite appealing in the current low-rate environment). At the time, I noted that this situation could quickly reverse itself if yields in the U.S. started to rise. Thanks to the recently passed $1.9 trillion stimulus in the U.S. some people think that moment has arrived and emerging markets are about to be hit by a wave of capital flight and potentially financial contagion. I disagree.
For better or worse, global investment flows are highly sensitive to financial conditions (both actual and expected) in the United States. When yields are low in the U.S., and expected to remain low for a long time, investors will seek higher returns in emerging markets. If yields in the U.S. are expected to rise, investors will often sell emerging market assets and revert back to the supposed safety of U.S. holdings.
When such sell-offs occur in emerging markets, it typically causes the currency to rapidly lose value against the dollar and countries with large current account deficits are especially vulnerable to this type of capital flight. Central banks can manage capital flight by raising interest rates or intervening in capital markets to try and keep the exchange rate from dropping too far too fast. But both of these options come with downsides.
Raising interest rates makes domestic borrowing more costly, and tighter monetary policy during times of economic stress is unpopular and potentially bad for growth. Central bank intervention in capital markets can prop up local currencies but it drains foreign exchange reserves, and can’t be sustained indefinitely. On the other hand, if the central bank just lets the exchange rate go, it can lead to a balance of payments crisis as debts denominated in foreign currency become impossible to service. Any policy move thus involves making judgement calls amongst a series of imperfect choices.
Analysts and central bankers have been on the lookout for the next Taper Tantrum, a replay of 2013, when the U.S. Federal Reserve signaled it would end its quantitative easing program. This caused yields on long-term U.S. Treasury bills to rise, which touched off capital flight in emerging markets and hit the currencies of Turkey, Indonesia, Brazil, South Africa, and India particularly hard. The $1.9 trillion stimulus package passed in the U.S. earlier this month is bringing back memories of 2013.
Basically, some investors believe the stimulus will drive higher growth and inflation (and lead to higher interest rates) in the U.S. over the long-term – not now, perhaps, but maybe ten years from now. Consequently, yields on long-term U.S. Treasury bills have started increasing, somewhat. This, in turn, has put pressure on emerging market currencies. Almost every currency in Southeast Asia, from the ringgit to the baht, has lost value against the dollar over the last month. How long can rising Treasury yields squeeze emerging market currencies before something gives?
The first domino has already fallen. On March 18, Turkey’s central bank raised the benchmark rate 200 basis points in an attempt to head off capital flight. President Recep Tayyip Erdogan immediately fired the central bank governor, which sent the lira tumbling. The question now is whether that was a one-off event, unique to Turkey, or a harbinger of a wider systemic round of emerging market capital flight and currency collapses?
Of course nobody knows the answer for sure, but it should be noted that Turkey was already in bad shape prior to March 18, with very high inflation and interest rates and a toxic political environment that forced its central bank to choose between equally terrible options. This is not the case everywhere. While Brazil and especially Turkey are feeling the heat from the rise in long-term U.S. bond yields, Indonesia’s currency is holding up pretty well so far thanks to a current account surplus and the monetization of some of its public debt.
Central banks in Southeast Asia generally have the policy space to raise interest rates if they need to, they have healthier foreign exchange reserves and most of them are actually probably welcoming a moderate depreciation in their currencies which will make exports more competitive. There are systematic forces at work here, but how each country will ultimately deal with rising U.S. bond yields depends on the policy choices they make along the way. Given all that, at least in my judgment, sounding the alarm bells at this juncture is premature.