While it's easy to bash the Fed for the damage wrought on domestic market mechanisms, the blame for a return of hot money-driven emerging market foreign exchange risk falls at the door of those EM economies that have become condemned to repeat history.
As U.S. Treasury Secretary John Connally famously told European finance ministers in 1971, concerned by exported U.S. inflation, the dollar is "our currency, but your problem."
Easy money and broken markets
Ever since the U.S. Federal Reserve rolled out its first round of quantitative easing in 2008, it has been nigh-on impossible to argue with the negative effects of central bank intervention on market mechanisms and its exacerbation of the business cycle. A sustained period of artificially low interest rates and excessive credit creation as a result of the Fed's intervention in the market has resulted in a volatile and unstable imbalance between saving and investment.
But anybody watching Emerging Market FX can see that this flood of cheap money has had much more destructive effects on less liquid economies as hot money flows inflate credit bubbles and drive volatility, while external capital ramps up BoP imbalances.
Of course, the Fed had intervened in the markets before. But the scale and duration of its intervention is unprecedented. Its intervention in the mortgage-backed securities (MBS) market on such a scale has skewed it to a degree that traditional macroeconomics are rendered useless. The Fed coupled its MBS purchases with government-sponsored enterprise purchases (GSE) - While Ginnie Mae securities are the only MBS that are explicitly underwritten by the U.S. government, it was also seen that there was an "implicit guarantee" for MBS backed by Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB). The intervention in the MBS market and in government-sponsored enterprise was done so with the explicit aim of reducing mortgage interest rates. And as a result it has created a near monopsony in the MBS market.
Combined Fed Treasury and MBS purchases currently run at USD85bn every month. In the constant speculation over Fed policy - will it taper? Won't it taper? - it's easy to lose sight of what a huge intervention this is. Every month.
Covering the cracks
Outside of the U.S., the Fed's monetary expansionist programmes drove hot money flows into emerging markets in the hunt for yield against record low U.S. interest rates. Investors could borrow at a pittance in the U.S. and emerging market economies were inflated as this cheap cash flooded into higher yielding assets.
This influx of foreign capital helped encourage consumption, driving inflation, and weaken external accounts.
But while there were some celebrating this supposed miraculous emerging market growth, this addiction to artificially cheap credit is a dangerous one. And many markets who went through the damage wrought by the Asian Crisis of 1997 are facing similar destruction again. As Thailand become dependent on hot money flows, asset bubbles were inflated, with a similar story in Malaysia and Indonesia. Fixed interest rates ramped up foreign exchange risk, and when Alan Greenspan hiked U.S. interest rates, it pulled the rug out from under those economies reliant on cheap credit.
But, as is often the case when cheap government-created credit increases the amplitude of the business cycle, private enterprise came co-mingled with government activity, with morally hazardous results. As corporate profits were swelled by easy money, that growth was seen by government as intrinsic to the economic health of the country. As such, corporates assumed the implicit government underwriting of counterparty risk on speculative transactions, essentially creating a Dutch book - making risk cheap and creating the conditions for accelerated asset inflation.
Does any of this sound familiar?
This cheap money has had a second effect on emerging markets - allowing governments to run large budget deficits. As a result, they have shirked from implementing the kind of structural reforms and supply-side liberalisation that Western economies implemented at a similar stage in their economic maturity.
India was one of those countries that embodied this trend - ramping up infrastructure spending while running up huge current account and budget deficits. And it is now paying the price. And rather than addressing problems head-on, India instead implemented knee-jerk policies - the Reserve Bank of India has raised import tariffs on gold three times as domestic investors try to protect themselves from a tumbling rupee. The new RBI governor, Raghuram Rajan has begun to change the direction of travel for the Indian economy, addressing problems head on. But the squeeze put on India by any talk of a tapering of the Federal Reserve's quantitative easing programme indicates just how exposed the Indian economy remains to any credit contraction.
But while India may have the economic heft to shift itself out of problems, the South East Asian economies so affected by the 1997 crisis seem unlikely to extricate themselves from danger. Although the '97 crisis forced most of the South East Asian currencies off their U.S. dollar currency pegs that exacerbated their problems and fuelled contagion, most remain tightly controlled, with foreign-exchange trading discouraged and limited to the non-deliverable forwards (NDF) market. These markets have been like a rabbit in the headlights ever since rumours that the Fed was going to taper started in May. And tapering isn't tightening. It is merely slowing the rate of monetary expansion.
If the status quo is maintained, when Western central banks begin tightening monetary policy, the credit contraction is going to rip through emerging market economies, tearing the highly exposed currencies to shreds.
Unless emerging markets can learn from mistakes of the past, they will continue to be at the mercy of violent credit contractions. Fed monetary activism is here to stay, and emerging markets need to learn how to survive it.