Taper talk is once again ruffling global markets as better-than-expected U.S. job creation feeds expectations that the Federal Reserve could start slowing down its $85 billion-a-month asset purchases, known as QE3.
In the past, even the slightest hint at tapering was greeted with dread. In May, the reaction in bond markets to an exquisitely hedged statement by Fed Chairman Ben Bernanke that the central bank was considering a taper was swift and brutal. Though Mr. Bernanke was reportedly surprised by the response, he shouldn't have been. He was, after three years of market-cheering, evermore accommodative U.S. monetary policy, changing that policy's trajectory. With little prospect of anything better than continued fiscal stalemate, the economy had become a monetary meth addict—and the monthly fix was now about to be cut back.
Emerging-market bond and currency markets were particularly badly hit. But the pain was not shared equally. The countries whacked hardest by taper-talk had large current-account deficits—Turkey, India, Indonesia and Brazil. Big-deficit countries also saw significant increases in long-term borrowing costs.
These nations had been cruising on QE3, comfortably financing excesses of consumption over production with dollars desperately scouring the globe for return. But the mere hint that the flow of dollars might be reduced was enough to send foreign investors into paroxysms of fear over depreciation and a risk of default. The countries whose currencies depreciated most following taper-talk were also the biggest beneficiaries of taper-interruptus—the Fed's decision in mid-September to back away from a strongly hinted-at decrease in asset buying. Their currency and bond prices rebounded strongly.
This is not the first time emerging markets have been hurled about by unconventional monetary policy in the developed world. A recent International Monetary Fund study, "Global Impact and Challenges of Unconventional Monetary Policies," found that the Fed's first round of quantitative easing from January 2009 to March 2010 resulted in $250 billion being withdrawn from emerging-market bond markets (under the logic that QE would drive the U.S. out of recession), while QE3 had the opposite effect, causing $91 billion to flow in (as U.S. asset prices had turned frothy).
The net effect of unconventional monetary policy in the U.S., U.K., Japan, and Europe on emerging-market bond flows since 2008, the IMF study found, has been trivial: a mere 0.22% of GDP. The volatility, however, with its attendant effects on currency, trade and investment, has been considerable. The Fed's oft-repeated refrain that what's good for jobs and growth in America is good for the world now rings somewhat hollow.
Finance ministers and central bankers in emerging markets have been increasingly vocal critics of the Fed-centered international monetary system. Taper talk was particularly traumatic for India, where the central bank was obliged to raise interest rates to counter capital outflows and imported inflation from a plummeting rupee, despite the country's slowing growth.
So how can emerging markets protect themselves in advance of taper attacks? The IMF study found that countries with a lower share of foreign ownership of domestic assets, a trade surplus and large foreign-exchange reserves have been more resilient. They've experienced far less volatility in their currency and domestic asset markets. This has policy implications: In good times, apply a firm hand to keep your imports and currency down, and exports and dollar reserves up.
Broadly, this is what U.S. congressmen call currency "manipulation," and it is hardly a prescription that the U.S. Treasury can endorse. Some would even punish countries that pursue such policies. In a Nov. 6 op-ed in the New York Times, for instance, economists Jared Bernstein and Dean Baker called for the U.S. to impose taxes on foreign holdings of Treasurys and tariffs on imports precisely to counteract them.
These policies are a recipe for more global trade and political tensions. And, just as with the standoff between congressional Republicans and the White House over debt and taxes, there is no meaningful effort under way to find common ground. Recent moves by China, Brazil, Russia, Turkey and Japan to move away from dollar-based trade will make things worse by undermining the multilateral trading system, as countries that don't want to stockpile each other's currencies will use trade discrimination to prevent imbalances.
The financial crisis has provoked a renewed and often heated debate in the U.S. about the application of rules versus discretion in monetary policy. The policy void created at the Fed over the winding down of large-scale monthly asset purchases—when, why, how much, and over what time scale—bears witness to the wider costs of unfettered discretion at the center of the global monetary system.
-- Benn Steil is director of international economics at the Council on Foreign Relations and author of The Battle of Bretton Woods. Dinah Walker is an analyst at the Council.
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