All eyes and ears are on the Fed as it ponders its first rate increase in nine years. IMF Managing Director Christine Lagarde fears a rerun of the 2013 “taper tantrum,” or what we have been calling a rate ruckus. Emerging markets are clearly vulnerable to renewed outflows, as capital chases higher yields in the U.S. and drives up the cost of dollar funding abroad.
Yet missing from the discussion is what other major central banks are doing. Specifically, the European Central Bank (ECB) and the Bank of Japan (BoJ) have ramped up their asset purchase programs in the past year, and are committed to creating large amounts of new liquidity until at least mid-2016.
As shown in the graphic above, the liquidity they intend to inject, combined, both this year and next is in line with that from Fed asset purchases at the height of QE3 in 2013. The new net global liquidity created by the ECB and BoJ in each of these years will be greater – even after subtracting the liquidity to be removed by the Fed through balance sheet contraction – than that created by the Big Three at any point since 2011.
Why is this good news for emerging markets?
First, asset purchases by the ECB and BoJ have a greater tendency to displace existing investment in government debt than do Fed purchases. As new issuance of government debt is smaller in the euro area and Japan than in the U.S., the ECB and BoJ will have to purchase a larger amount of secondary market assets from private investors in order to meet their target quantity of purchases.
Second, investors displaced by ECB or BoJ asset purchases are no less likely to invest in emerging markets than those displaced by Fed purchases. To see this, let’s walk through their investment options.
One is domestic non-government bond or equity markets. In fact, these are smaller in the euro area and Japan than in the U.S., which suggests less scope to reallocate in such markets.
For one (large) class of investors – banks – there is also the option to increase lending to households and businesses. But the economic outlook remains weak in Europe and Japan, and weaker than in the U.S. at the time of the Fed’s QE3. This suggests fewer attractive opportunities to expand lending.
If domestic markets and bank lending are likely to absorb less of the liquidity than in the U.S., then a greater proportion of money displaced by ECB and BoJ purchases will flow to foreign assets. Whether this is to emerging markets – and which ones – will depend on investors’ risk tolerance. And there is no obvious reason why investors displaced by the ECB or BoJ would be any less risk-loving than those displaced by the Fed.
In short, a tightening of U.S. monetary policy does not mean a tightening of global liquidity. In fact, the ECB and BoJ look set to expand it more than we’ve seen in any two-year period since the start of the crisis in 2007-8.