On July 17th the world's financial community were treated to another performance by the Chairman of the US Federal Reserve, Ben Bernanke, during his semiannual appearance before Congress. Dr. Bernanke attempted to 'clarify' the Fed's position regarding tightening of monetary policy. His testimony was so full of conditional phrases that it is doubtful that he clarified anything. Apparently the Fed will end the quantitative easing bond buying program when and if the board feels the time is right.
I am not sure if the most recent pronouncement from on high was any more enlightening than the standard Delphic prophecy, but what did seem clear was that the easy money would end, sooner or later. If we take Dr. Bernanke at his word, the stimulus will end when the US economy is stronger, which he forecasts to be soon. With a stronger economy, the end of QE is supposed to have a small impact in America. But there are other countries and other economies in the world where the effects might not be so benign.
It is estimated that about $4 trillion has washed around emerging markets since the stimulus programs started 4 years ago. The impact has significantly lowered Asian bond yields, boosted equity markets and pushed local currencies higher against the dollar. The impact has varied widely from country to country. In Singapore, for example, the inflation rate rose only 0.5%, while in Indonesia inflation increased by over 4%. Inflation increased in the US by 0.6% at most.
This impact no doubt will increase if and when the Federal Reserve's policy moves to less stimulus. In the past month alone, 19 of the 24 emerging market currencies tracked by Bloomberg fell against the dollar. Cooing from central banks helped to stem the fall. But for all the rhetoric, US interest rates have risen 1% in the past three months and have not retreated.
Higher US interest rates will have the greatest impact on emerging market bonds. One of the most promising developments since the Asian crisis 15 years ago has been the rise of local bond markets. Higher credit ratings and often very large foreign reserves have benefited local debt. With more companies and governments able to borrow in their own currencies, there is less of a chance for disaster when the currency tanks as recently occurred. It does not mean that the problem has disappeared.
It is estimated that the developing world needs $1.5 trillion in external funding every 12 months. If the markets dry up, this could create a very large problem. The general belief has been that emerging markets are not large debtors like the US or southern Europe, but this depends on the country. India, Turkey, South Africa, and Brazil all have large current account deficits and their currencies have suffered as a result. Lower commodities prices and less demand will make servicing the deficits more challenging. Higher interest rates will certainly magnify the problems.
These problems became more evident last month when money started to pour out of emerging market bond funds. Last year emerging market bond funds were the beneficiaries of the 'search for yield' precipitated by the interest rate suppression of the Fed. They averaged inflows of .4% per week. With a potential Fed policy change, the flows recently reversed and the average outflow was 1.2% per week. The foreign investors who had piled into the local currency debt have started to flee.
It is not just the occasional pronouncements of central banks that have caused trouble. With so much money desperately looking for decent returns, some have gone to poor quality lenders. Three examples are Mexico's three leading homebuilders - Desarrolladora Homex, Corp. Geo and Urbi Desarrollos Urbanos. All three companies are junk rated, but last year they had no problem with raising $2.75 billion from fund managers. Interest rates as high as 9.75% for ten year notes was too much to resist.
The money managers now wish they had. These bonds have plunged by an average of 55% this year. The reason for the fall had nothing to do with tapering. Urbi, Geo and Homex are specialized in suburban developments of single family homes. The Mexican government decided to shift its subsidized housing program towards the construction of apartment buildings in city center. The builders are stuck with a glut of unsold homes and undeveloped land. It appears that all of the companies will have to restructure their debt, and the bond holders will have to take significant haircuts.
It would be simplistic to believe that default issues are limited to the Mexican housing market. Yield deprived investors allowed companies all over the world to tap the bond market for the first time. For many it will be their last.
The tightening or tapering comes at a particularly bad time. The Chinese growth slowed to 7.5%. Markets sighed with relief. They expected a far lower number. Their expectations were probably more accurate. The real number though was probably much lower. The Chinese leadership is intent on restructuring the economy and have vowed not to provide additional stimulus. This will impact many emerging markets whose main trading partner is China and no longer the US.
It is not just that individual bonds or countries have issues. The bond market is also structurally weak. The size of global fixed income markets has grown from around $40 trillion to $100 trillion over the past 10 years. But as the size of the market increased so did the risks. Regulatory changes require banks to hold less inventory, so the market has become more illiquid. Poorly understood feedback loops make the situation more dangerous. According to Nobel Laureate Robert Merton, "The post-crisis environment has a much greater intensity of connectedness in terms of credit sensitivities than before." So what happens anywhere will have a greater impact on everyone else and it may happen very quickly.
Ben Bernanke has been desperately walking back the comments he made in May. He has been fairly successful at it. But he has simply reflated a bubble that he created. Sadly the worst impact will not be in the US, but in emerging markets where the pain will be much greater.