Wednesday, January 29, 2014

The Ultimate High Cost and Collateral Damage of Quantitative Easing

Recently, the mainstream media has been noting the cracks that are starting to appear in the world's emerging markets and currencies.  A commentary by Guillermo Ortiz, former Governor of the Bank of Mexico looks at the challenges that the world's emerging markets will face as the Federal Reserve (and other central banks) return to "business as usual".  Here is the opening paragraph from his commentary which pretty much says it all:

"Although all crises share common traits, each is very particular in its own way. At times the resolution of a crisis can create a new set of problems for which the original response is ill-fitted. In rare cases, these problems become as substantial as the original catastrophe and overlap with the recovery. In these circumstances, there is no rule- book to guide policy. The challenge then is to adequately prepare for the ensuing disruption. Such is the case of the current global conundrum. The unprecedented monetary stimulus, which flooded the global economy after the great financial crisis, now risks destabilizing the world economy and the international financial system if the appropriate policy measures are not taken to limit the potential costs of collateral effects from unconventional policies." (my bold)

Mr. Ortiz notes that the massive response to the global financial crisis has inflated the assets of the central banks of the G-4 nations to an unprecedented $10 trillion and are expected to add an additional $2 billion by the end of 2014.  To put these assets into perspective, here are the sizes of the central bank balance sheets in terms of their respective nation's GDP:

United States - 22.6 percent
United Kingdom - 26.7 percent
Euro Area - 27.4 percent
Japan - 31.5 percent

The author also notes that, in contrast to advanced economies, the world's emerging economies have fared quite well as shown here:

Advanced Economies - av'g growth since 2008 - 1 percent
Emerging Economies - av'g growth since 2008 - 5.3 percent

In large part, the ultra-easy monetary conditions have led to a massive flow of capital to emerging markets.  Normally, this would be a good thing because it supports economic growth in developing economies, however, it can result in excessive currency appreciation and unstable increases in the prices of assets, particularly bonds.  Since 2008, there has been a strong rally the value of emerging market assets, largely because the near-zero interest rate policies of the four major central banks have led investors to seek yield rather than investing in capital.  Since 2010, private capital flows to emerging markets have averaged $1.1 trillion.  This has had the unintended consequence of creating a boom in the issuance of both corporate and sovereign debt throughout the world's emerging economies; since 2008, issuance of public sector debt has risen by 50 percent and dollar-denominated corporate debt has increased by a very substantial 350 percent!

Not surprisingly, Mr. Ortiz focusses on the repercussions of the influence of ultra-easy money on Mexico.  Here is a summary of what has happened to Mexico:

1.) Net private capital inflows since 2010 have averaged over $60 billion, skewed toward government debt and equity investment.

2.) Foreign holdings of Mexican government debt have risen from 9 percent in 2007 to 37 percent in 2013.  I would suspect that this is what could be termed "hot money"; investors will bail on these riskier bonds once yields of Treasuries rise to historical norms, pushing fixed income prices down and yields up.

3.) Interest rates on two- and ten-year notes have fallen to 3.8 percent and 4.4 percent respectively, down from their 2001 to 2007 averages of 8.5 percent and 9.1 percent respectively.  This has the unintended consequence of allowing Mexico (and other nations) to issue massive volumes of debt with minimal increases in overall debt interest least, for now.

Here is a chart showing what has happened to the yield on Mexico's ten year bonds over the past five years, noting the rather sharp jump in yield in May 2013 and the gradual drop in yields as investors, seeking yield, purchased increasing volumes of Mexico's debt, pushing prices up and yields down:

Looking further afield, foreign holdings of Turkish debt has risen from 11 percent in 2008 to 30 percent in 2013 with over 90 percent of Turkey's total external debt being denominated in foreign currencies.   South Africa has seen foreign ownership of its government debt rise from 25 percent in 2008 to 38 percent in 2013.  Obviously, the policies of the world's major advanced central banks has created distortions, the unwinding of which could create huge problems for the world's emerging economies as the Fed, in particular, tapers its experiment.  All investors needed to do is look at what happened in May 2013, as the Fed signalled its intention to "contemplate tapering" if we want to see what lies ahead.  Investors unwound their highly leveraged positions, resulting in a combined net outflow of $25 billion worth of emerging market equities and bonds.  Emerging market government bonds fell 5.3 percent, corporate bonds declined 7.2 percent, currencies depreciated by 5.1 percent and equities dropped by 13.9 percent.  A harbinger of things to come? Absolutely

Here is a chart showing what has happened to the yield on Turkey's ten year bonds since 2010, noting that the yield has risen sharply from just over 6 percent in mid-2013 to its current level of 10.7 percent:

Here is a chart showing what happened to the yield on South Africa's ten year bonds since 2009, again, noting that yields rose from 5.77 percent in mid-2013 to their current level of 8.3 percent:

In both cases, as I noted above, the interest rate on both emerging nation's bonds was pushed to an artificially low level thanks to the current zero-interest rate policies of the Federal Reserve et al and have now risen by a very substantial amount, an amount that could well prove to be punitive over the long run particularly given that many emerging market nations have issued unprecedented levels of new debt..

In the specific case of Mexico, the very mention of tapering caused the peso to decline by 7.9 percent, equities dropped 6.2 percent, dollar-denominated corporate bonds fell by 6.7 percent and the yield on 10-year government bonds increased by 133 basis points (compared to 60 basis points for U.S. Treasuries).

It looks like investors are already starting to feel the fallout from the unsustainable policies implemented by the Federal Reserve and its G-4 central bank peers.  The experience of Mexico in mid-2013 looks like it may well be the predictor for what will happened to the world's emerging markets as central banks reverse course.  Unfortunately, hundreds of millions of people in developing nations are likely to suffer the brunt of the damage done by five years of fiscal experimentation.

Apparently, the piper must be paid.


  1. So stimulating economic growth during a deep recession with easy money has a downside. I imagine the downside of NOT easing would be far worse than some sloshing around of yields and forex.

    1. But QEs to infinity are bad.For example,it has ultimately dawned on those concerned that mere QEs will not solve problems.
      As if to add fuel to fire,QEs are accompanied by the misuse of the Derivatives ti DEFLATE!That's going too far.
      Please google:
      Debasement of Coinage Nicolaus Copernicus Keynes