Daily Archives: January 8, 2014

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Debates persist in the US and eurozone about growth and job creation versus fiscal discipline. This false choice diverts fiscal focus away from a balanced approach that could achieve both imperatives. Such false choices also contribute to the failure of our political systems to better address continuing hardship through advancing growth and employment, and through programmes such as the unemployment insurance extension. Moreover, that political failure has also contributed to central bank decisions to employ unconventional monetary policies that create widely under-appreciated risks.

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The US recovery remains slow by historical standards – even if recent signs of improvement are borne out. One reason is that our unsound fiscal trajectory undermines business confidence, and thus job creation, by creating uncertainty about future policy and exacerbating concerns about the will of Congress to govern. Business leaders frequently cite our fiscal outlook as a deterrent to hiring and investment.

A sound fiscal trajectory is also a prerequisite for interest rates conducive to growth. Continued unsound fiscal conditions will almost surely destabilise markets at some future point. Recent reductions in deficit projections do not change the basic structural picture – except that healthcare cost increases are slowing – and are partly based on sequestration, a terrible policy that already looks too onerous to stick.

In the eurozone, the threat is more immediate. Bond markets in troubled countries were in dire conditions until the European Central Bank’s famous – and as yet unimplemented – 2012 promise to do “whatever it takes”. But ECB actions will not address fiscal and structural issues critical to healthy recovery. Also, the ECB cannot buy sovereign debt indefinitely without triggering capital flight from corporate and sovereign debt markets and the currency. The ECB has bought time, but if that time is not used for policy reforms that win market confidence, bond markets will eventually destabilise.

Unconventional policy decisions by central banks are sometimes justified as the only available tools in the absence of necessary government policies. The right criterion for action, however, is not the absence of alternatives, but an assessment of costs and benefits. In the US, the Federal Reserve’s first programme of quantitative easing was a courageous response to the crisis. And in the eurozone, too, it was imperative to stem the crisis. But the key policy issues have always rested with political leaders.

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In the US, there are widely posed questions about the benefits of QE3, but the risks are significant. One is that central bank action will reduce market pressure on political leaders to act. Another is financial moral hazard, where that same comfort may increase reaching for yield in riskier asset classes. The greatest risks of all surround exit strategy.

Unwinding the vast enlargement of the Fed’s balance sheet and liquidity greatly increases the usual risks in monetary policy aimed at price stability, growth and employment. Greater uncertainty means navigating uncharted waters, with heightened chances that tightening leads to a significant downturn. Some suggest that raising interest rates on banks’ excess reserves at the Fed, instead of selling bonds, could limit the risks. But there are no magic wands. No one can reliably project the rate increases needed or the likelihood of destabilising reactions among lenders and borrowers.

Yet waiting too long to tighten heightens the risk of inflation at some point. The Fed’s dramatic expansion of bank reserves could feed excessive credit growth. Along with the possible erosion of Fed credibility on inflation, that could also feed inflationary expectations.

Whether or not QE3 was wise to begin with, the question is what to do now. So-called “tapering” will not withdraw liquidity. Time will tell whether tapering – now under way on a small scale – will increase market interest rates, or whether tapering is already priced in. (Recent rate increases may also reflect improved economic data.) Continued purchasing reduces the risk of market reaction, but increases future unwinding risk. Confidence generated by a sound fiscal regime could help ameliorate both risks.

Such a regime should be enacted now to stabilise, or preferably reduce, the ratio of debt-to-gross domestic product over 10 years, and protect discretionary spending. Implementation, designed in ways difficult to undo, should be deferred for a limited period to allow for recovery. Fiscal discipline could provide room for reasonable stimulus to create jobs. The partially cancelled sequestration should be fully rescinded to eliminate its fiscal drag. Fiscal funding should come largely from revenue increases and beginning the entitlement reforms necessary for long-term sustainability – as President Barack Obama has proposed.

Structural deficit reduction would address growing deficits in the decades beyond the next 10 years. The eurozone, too, should reject false choices. Instead, it should strike the right balance between fiscal discipline to win market and business confidence, and macroeconomic room for growth.

Unconventional monetary policy and stimulus can be part of a successful economic programme for a period of time. But they are no substitute for fiscal discipline, public investment and structural reform.


The writer is a former US Treasury secretary

Now among the world’s most dynamic emerging markets, Turkey has proven a remarkable success story in recent years. In the decade since Recep Tayyip Erdogan, prime minister, and his Justice and Development Party (AKP) first rose to power, economic growth has broadened beyond the traditional northwestern Istanbul-Ankara-Izmir triangle and the well-connected secular elite to include new companies and investors from the country’s heartland. Per capita income has tripled in nominal terms, and Turkey has become an influential actor on the global stage.

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One striking aspect of last year’s markets is the extent to which emerging market assets underperformed those in advanced economies. As investors search for returns this year among some frothy asset markets, such unusual underperformance attracts even greater attention.

Emerging markets’ underperformance was broad-based, affecting virtually every asset class. EM equities underperformed the aggregate world index by a stunning 29 percentage points as measured by their MSCI index components. In external credit, the return on EM sovereign bonds was a notable 14 percentage points lower than that on high yield bonds (as measured by JPM EMBI Global and ML HY indices, respectively). Local currency EM bonds did even worse, returning minus 9 per cent according to the GBI EM index.

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Some “classic” factors contributed to the disappointing performance of emerging markets. Top line revenue suffered on account of more muted growth and lower government stimulus, with related global demand uncertainties compounded by structural changes taking place in China. Profit margins also came under pressure due to inflexible cost structures.

Meanwhile, highly visible company debacles, such as OGX in Brazil, reignited concerns about corporate governance and legal protections; as did political instability in countries such as Turkey and Ukraine.

Financial engineering

Moreover, and again in contrast to their US counterparts, EM equities did not benefit from the financial engineering that many corporate treasurers pursued as a result of the interest rate policies adopted by G3 central banks. For example, aided by Federal Reserve policy, US company boards authorised as much as $750bn in share buybacks in 2013 (equivalent to almost 6 per cent of the capitalisation of the S&P 500 at the start of 2013).

As significant as these factors are, they do not fully explain the breadth and size of emerging market underperformance in 2013. Also, they are not enough to confidently anchor predictions for 2014. If they were, broad emerging market exposure would probably outperform this year, given the stabilisation in growth rates, higher export receipts, and declining Fed policy support for US corporate buybacks and dividend hikes.

To shed more light on what happened in 2013 and what is likely to occur in 2014, we need to look at three factors that many had assumed were relics of the “old EM”.

First, and after several years of large inflows, emerging markets suffered a dramatic dislocation in technical conditions in the second quarter of 2013.

The trigger was Fed talk of “tapering” the unconventional support the US central bank provides to markets. The resulting price and liquidity disruptions were amplified by structural weaknesses associated with a narrow EM dedicated investor base and skittish cross-over investors. Simply put, “tourist dollars” fleeing emerging markets could not be compensated for quickly enough by “locals”.

Policy makers stumble

Second, 2013 saw stumbles on the part of EM corporate leaders and policy makers. Perhaps overconfident due to all the talk of an emerging market age – itself encouraged by the extent to which the emerging world had economically and financially outperformed advanced countries after the 2008 global financial crisis – they underestimated exogenous technical shocks, overestimated their resilience, and under-delivered on the needed responses at both corporate and sovereign levels. Pending elections also damped enthusiasm for policy changes.

Finally, the extent of internal policy incoherence was accentuated by the currency depreciations caused by the sudden midyear reversal in cross-border capital flows. Companies scrambled to deal with their foreign exchange mismatches while central bank interest rate policies were torn between battling currency-induced inflation and countering declining economic growth.

Absent a major hiccup in the global economy – due, for example, to a policy mistake on the part of G3 central banks and/or a market accident as some asset prices are quite disconnected from fundamentals – the influence of these three factors is likely to diminish in 2014. This would alleviate pressure on emerging market assets at a time when their valuations have become more attractive on both a relative and absolute basis.

Yet the answer is not for investors to rush and position their portfolios for an emerging market recovery that is broad in scope and large in scale. Instead, they should differentiate by favouring companies commanding premium profitability and benefiting from healthy long-run consumer growth dynamics, residing in countries with strong balance sheets and a high degree of policy flexibility, and benefiting from a rising dedicated investor base.

Mohamed El-Erian is chief executive and co-chief investment officer of Pimco

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