Tough choices for EM policy makers in a post-QE world

Emerging market economies with current account deficits have had little to smile about since Ben Bernanke first mentioned ‘tapering’ of QE in May.

This chart (after the break) from Aberdeen Asset Management shows the strong correlation between current accounts and currency strength. Countries such as Indonesia, India, Turkey, South Africa and Brazil, running large deficits, are being punished with drastically weakening currencies.

Source: Aberdeen. Click to enlarge

They can do little to fight it. In Indonesia, the price of supporting the currency has been huge but the exercise has been ineffective. Indonesia’s foreign exchange reserves shrank by nearly a fifth to less than $93bn between January and July, as the central bank tried to defend the rupiah. The currency lost 6 per cent of its value against the dollar in that time; since August it has lost more than 9 per cent, in spite of two interest rate hikes in as many weeks.

Where can countries with large current account deficits look for relief? Not to exports, says Edwin Gutierrez, fixed income portfolio manager at Aberdeen. While weaker currencies will help exporters, the relief won’t come any time soon.

“The effect of currency depreciation on exports operates on a lag. It will take effect by the tail end of 2014. But the current account deficit needs to be financed now,” he says.

Nor will foreign investment flows help. On the contrary, every man and his dog is shifting out of emerging markets assets since Bernanke first mentioned tapering in May. EPFR, which monitors fund flows, says US mutual funds investing in emerging markets bonds – combining nearly $300bn of institutional and retail assets – have see redemptions of 9 per cent since then.

“The only cure for these dangerous current account deficits is softening domestic demand,” Gutierrez says.

This is a bitter pill for policy makers in Jakarta and Delhi. For a view of how bitter, Gutierrez suggests looking to central and eastern Europe.

Source: Aberdeen. Click to enlarge

Croatia was running a current account deficit of 7 per cent of GDP and had growth just above 6 per cent in 2007. By 2012, with the current account finally balanced, growth was at minus 3 per cent: for only one of the last four years has it been positive (an anaemic 0.1 per cent in 2011). In Hungary, Poland and Romania the trend is the same: lowering the deficit has been mirrored by sharply curtailed growth.

“Worsening current account deficits trigger currency weaknesses. The adjustment of external balances is possible but requires much slower growth,” says Gutierrez. “Growth-oriented EM policy-makers face tough choices in a post-QE world”.

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