Cees Bruggemans: Consulting Economist Bruggemans & Associates
Cees Bruggemans: Consulting Economist Bruggemans & Associates

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SA & the Fed trap doors


Sometimes, the obvious stares us in the face.

As much in Jurassic Park when the wrong dinosaur, however innocent looking, will eat you shortly. Also, as in modern times when the Fed has for very long now carried the world on an ocean of liquidity creation, supporting many, but where some expect the return journey to be as bumpy, in reverse.

It is the latter preoccupation, getting floored by Fed good intentions as it rolls back its unconventional policy actions, that has the close attention of many central banks around the world, especially exposed Emerging Market (EM) ones.

Many countries have in recent years been subjected to capital flow and currency shock, dislocating domestic economies. And they can see the next such episode shaping and want to be ready for it when it hits, minimising collateral damage as far as possible (maintaining stability even in the crosshairs of a raging global hurricane).

For much of the early to mid-2000s decade, EMs were beneficiaries of a global commodity supercycle enriching them. In addition, the world lived off Chinese globalization productivity gains, with many trading nations accumulating huge trade surpluses, while others were subjected to large capital inflows, driven by easy monetary policies in advanced countries and resulting yield-seeking investment flows.

In the middle of all that, the Rand started at 13.85:$ (late 2001) and saw 5.60:$ (late 2005). A memorial ride.

Since then the Rand has seen 11.50:$ again in late 2008 at the height of the Lehman crisis, recovered back towards 7:$ by mid-2011 upon the back of supportive Fed and ECB policies and commentaries, and has since then gone back to nearly 11.50:$ this January before correcting through to today near 10.30:$ (but as yet not having decisively broken out of this latest depreciation channel).

This latest three-year bear experience has been widely shared by many other EM currencies. Throughout this period there was weaker global growth as the 2009 recovery increasingly struggled to maintain momentum. Chinese growth steadily stepped down, and things were further complicated by US fiscal crisis threats and Fed signalling it could not indefinitely continue with unconventional policy support.

From this year the Fed started to taper its QE bond buying, with growing speculation as to when it would finish, and start normalising its extremely low interest rate levels, too.

The end of the commodity supercycle boom, peaking out in 2011, along with growing concern about slowing Chinese growth and the onset and reality of Fed exiting unconventional policy were the toxic cocktail that fueled renewed EM currency weakening these past three years.

But with as kicker that today we are probably only half way through that trauma as the worst, for markets, still lies ahead as the Fed will only start raising its rates from sometime in 2015 and will then have a long way to go back to normality, starting at zero and eyeing eventually 3%-4% Fedfunds.
As the conventional wisdom has it, "when Fed monetary policy firms, it usually causes a problem".
This potentially two-step confrontation scenario for many exposed currencies has had the firm attention of many EM central bankers for quite a while now. What to do to counter the possible disruptive movements and influences?

Not a few EMs have increased their interest rates, including our SARB, to reflect changed risk/reward metrics and prevent or stem undue capital outflows as far as possible. But for many what has so far been seen since 2011 may prove child's play through 2017/18 as the Fed normalizes rates.
At least, that is the single biggest concern.

As this Fed trap door becomes ever more threatening underneath EM feet, a variety of reactions can be observed. One is the inability to do anything, being powerless, and going with (surrendering to) the flow.

For those countries deciding so challenging times may await.

As Eswar Phasad puts it, "once speculators smell blood, they attack a currency relentlessly and foreign reserves can evaporate quickly". One only needs to examine the Asian Contagion of 1997-1998, but also late 2008.

Given all this, there is a strong groundswell among EMs not just to await their fate and see their currencies further mauled from present already undervalued levels, giving negative impulses to their asset markets and inflation (and growth) but to do something to counter so much new instability as far as possible.

For many the only way to do so is to ensure having enough foreign reserves to be able to absorb any shock outflows. Yet conventional views of reserve adequacy (enough to cover short-term external debt or six months of imports) are no longer relevant.

During the worst of the 2008 crisis, some EMs with massive reserves lost nearly a third of them in less than a year. According to the ECB, Russia similarly in recent months has suffered $160bn outflows.
Today no one knows exactly how much reserves will be enough to offer adequate protection against instability, only that "more is better".

In recent months the sense of global panic about imminent Fed tapering and its implications that was so pronounced last year has died down noticeably. Even as the Fed steadily tapers this year towards ending bond buying, private capital has been flowing back to EMs and other risky destinations. The Bank of Japan may provide further monetary boosts in months to come. China has taken forceful steps to prevent the Renminbi from appreciating further.

All these trends add to the pressure on other Asian EMs to make hay while the sun shines, holding down the value of their currencies and accumulate foreign reserves, and invest these in government bonds of advanced economies, especially the US.

One says "especially the US" because it has been observed in recent years that when forex stress was at its worst, the Fed proved willing to provide Dollar swaplines to select EMs, but only select ones rather than all-comers, a fact that wasn't lost on those denied this critical strategic access.

And one criteria, apparently, that was used by the Fed in granting such access was the size of a country's forex reserves, with its Dollar component effectively serving as collateral in case of disaster, important to the Fed with an oversight body like the US Congress.

Thus for any EM to be accumulating reserves, even huge excess reserves, at this juncture serves a dual purpose.

Like the Ant, and unlike the Grasshopper, hoarding reserves now will likely pay good dividends once the accompanying instability of Fed rate normalisation starts to be felt during 2015-2017/18.

In addition, it can serve as super collateral when next time Fed swaplines are sought in a crisis emergency, potentially levering off such reserves to match any market swamping tactics.

The present window to accumulate is of unknown duration but may be short, the stressful times ahead equally unknown in duration but potentially at times severe.

With this as backdrop one notices SA forex reserves having fallen to $45bn over the past year, though not by much, rather than having been built up further (even if this is a costly option, considering there was probably no Treasury sympathy at a time when fiscal space was so tight).

But then the Rand was under more pressure than most, the worst EM performer last year, though coming back from oversold conditions this year, yet this opportunity apparently not being fully used to replenish and further bolster the reserves.

Instead, we raised interest rates in January, as have done other EMs, and we have heard a drumbeat of opinion about more rate increases to come, heading off inflation impulses, but seemingly really aimed at preventing Rand weakness that could have such inflationary consequences.

Whether that was the right horse to bet on with a cronically weak domestic economy, and a looming potentially roguish Fed, rather than go for more forex reserve accumulation and accepting the weaker currency, time will tell.
Eswar Prasad "The coming currency clash in Asia" Wall Street Journal, 8 April 2014
Cees Bruggemans
Consulting Economist
Bruggemans & Associates
Website  www.bruggemans.co.za
Email  economics@bruggemans.co.za
Twitter  @ceesbruggemans

SA & the Fed trap doors

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