With Or Without Tapering, The Fed's Plans Will Have Dire Consequences

Includes: CU, EEM, GLD, IAU, JJC, VWO
by: Mingdong Wu

In today's intertwining global economy, global currency exchange system, local economic activities and international trade balance are all interconnected. Any disruption in one could result in serious and unexpected consequence to the other. The old rules of macroeconomics have morphed under this new global economic system as many agreements among countries and complex financial tools developed for international trade do not exist when such macroeconomic theories were uncovered or developed. The quantitative easing program (QE) since November 2008 is an unprecedented experiment by the US Federal Reserve to boost US consumer and investor confidence, and is aimed to boost US economic activities. The most significant and direct benefit of such large amount of money printing by the Federal Reserve is the rapid recovery of asset prices such as for housing and stock in the US. Without much help from the fiscal reform by the US government in recent years, however, the pace of job creation in the US has been slow. Now, as the Fed announced tapering, or the gradual ending, of the five-year quantitative easing in the US, the eventual conclusion of the QE may pose a great economic threat to the livelihood of millions, especially to those living in the emerging market countries, and will certainly affect people here in the United States. Here is why.

The United States is the largest economy in the world. Since the announcement of quantitative easing in November 2008, the US monetary base has expanded materially as a direct result of the Fed's purchase of various financial assets. According to the Federal Reserve Bank of St Louis, our monetary base has today exceeded $3.3 trillion from about $800 billion at pre-recession level in 2008.

Source: Economic Research, the Federal Reserve Bank of St. Louis

The significant increase in the supply of money should have resulted in rapid depreciation of the US dollar, and all other currencies should have significantly appreciated against the US dollar. This is the basic supply demand equation. However, the US dollar collapse as predicted by some economists did not happen. For instance, UUP, an ETF tracking the performance of the US dollar against six major currencies, was trading at around $22.5 in the summer of 2008 and is now trading at about the same level. The main reasons behind such phenomenon are the easy flow of money worldwide permissible under today's global currency exchange system and the need for international trade competitiveness for many emerging market countries.

When the US Fed started to print money with quantitative easing, our trading partners, especially many emerging market countries, decided to increase their own local currency supply concurrently to avoid large local currency appreciation. Their primary goal is to maintain the existing international trade balance, remain competitive against other US trading partners in international trade and therefore avoid potential large current account deficit. This is the game of competitive currency depreciation. Please keep in mind that today the US dollar is the main reserve currency for most countries. It is very easy politically to sell local currencies against the US dollar because the rapid increase in a country's US dollar exchange reserve is perceived to be a good thing for the local economy. While printing local currencies, the foreign central banks are soaking up the excess US dollars created by the US Fed. As a result, foreign exchange reserves for many emerging market countries went up and local economic activities increased due to increased local money supply. Here, please note that the local currencies of those emerging market countries are not reserve currencies and no other central banks, or foreign private investors, want to buy and hold such newly printed paper. Therefore, all the extra local money created went into the local economy. How efficient such extra capital is invested depends heavily on the structure of the respective countries' local economic system. Everything looks good and everyone is enjoying a great party of global economic recovery, at least before the QE stops.

Below is the chart for the Indian rupee against the US dollar from January 2008 to August 2013. The Indian rupee only appreciated modestly during the initial period of the US quantitative easing program and started to depreciate quickly against the US dollar after tapering was announced.

Source: eXchangeRate.com

With the announcement of tapering by the Fed in June 2013, things have suddenly reversed course. The increase in the US monetary base is expected to slow and eventually, the US monetary base will start to shrink with the maturity of various financial assets on the Fed's current balance sheet. Therefore, the supply of the US dollar is moderating and the US dollar is expected to appreciate. At this time, those foreign central banks who bought the US dollar during the past five years should start selling the US dollar while buying back its own local currencies to support the exchange rate. But the effect is minimal. Why? Because selling the dollar will drain its foreign exchange reserve and lead to perceived weakness in its local currency, especially for those emerging market countries with large current account deficit. In addition, for those countries that have increased its local money supply significantly over the past five years, if its central bank chooses to reduce its local monetary supply in the short time frame, the local economy in such country will face great uncertainty as its economy has been on "steroids," or growing with the help of excess money supply, during the US quantitative easing period. Let's look at how various central banks have responded to the Fed tapering.

For example, India and Indonesia are busy selling the US dollar to support their own currencies. If they don't, their local currencies will continue to rapidly depreciate, their current account deficit will worsen because imported raw materials and goods will become more expensive, and foreign investments will dry up because no foreign investors want to be left holding the bag of a rapidly depreciating currency. For both countries, their foreign exchange reserves are a limited resource. In addition, there is a limit on how much local currency may be suddenly withdrawn from the local economy. If they stop intervening or continue to increase local currency supply as before, the local currency depreciation will accelerate and the country may face great risk of inflation. This is something no government wants to see.

Same process is happening in China. Although China has a much larger domestic economy and the largest foreign exchange reserve, the reduction of local money supply has resulted in a mini liquidity crisis at major Chinese banks within a week after the announcement of tapering by the Fed. Subsequently, the Chinese central bank reluctantly injected more money into the local banking system. However, because the Chinese Yuan is not a freely-exchangeable currency and China has a large current account surplus, if the Chinese government wishes, China may for a long period of time avoid currency devaluation as faced by other emerging market countries.

In summary, if tapering happens as expected, many emerging markets will either have to reduce local money supply and therefore face short-term pain in their local economic development or if they choose not to reduce local money supply, may face long-term inflation risk as their currencies continue to depreciate. In today's intertwining global economy, their slower local economic activities will be contagious and will soon affect the long-term growth of the US economy, especially to those companies with heavy emerging market exposure. US exports to those countries will slow down and commodity prices, priced in US dollar, will drop due to weaker demand. Under such a scenario, I recommend investors to stay away from investing in the emerging markets for the next several years, especially in those countries with large current account deficit. Aggressive investors may choose to short those commodities with strong connection to the global economic growth, such as copper.

On the other hand, if the US Fed decides to continue the quantitative easing for an extended period, as long as the market expectation is for the US monetary base to continue to expand, asset prices, both for housing and stock in the US, will continue to increase. However, at a future date, we will face massive inflation because all central banks are busy printing their own currencies to counter local currency appreciation against the US dollar. Then, gold should be a key component of your investment portfolio.

With or without tapering, the Fed's plans will have dire consequences.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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