The G20 is meeting this coming weekend. It will assemble in Australia.
Officials are saying that "the main issue will be the recent turmoil in emerging markets (EM) as the US Federal Reserve starts to taper its asset purchases." This quote is from Robin Harding in the Financial Times.
Harding cites the statement by Douglas Rediker of the Peterson Institute for International Economics: "the current EM fragility is likely to be front and center ..." And, the session could experience a lot of finger pointing. Those that say the EM countries "didn't undertake the right domestic actions …" and the EM countries that "will point back."
The name-calling has already begun. I have already quoted the attack of the governor of the Reserve Bank of India, Raghuram Rajan, who called the United States selfish for beginning to taper its purchases of securities. He further warned that "international monetary co-operation has broken down."
Mr. Rajan, formerly, was a professor in the business school at the University of Chicago and, in my mind, a very good economist. Now, Mr. Rajan is the head of a central bank and has to play the games that central bankers must play.
Unfortunately, India is one of the group people are now calling "the fragile five," which, in addition to India, includes Turkey, South Africa, Indonesia, and Brazil. These countries have been facing severe selling pressure on the value of their currencies in foreign markets. Two other countries, Kazakhstan devalued its currency last week, and Argentina devalued its currency last month.
In December, the Open Market Committee of the Federal Reserve System voted to drop its purchases of securities from the financial markets from $85 billion per month to $75 billion. The Federal Reserve then did what it said it would do: in January it added only $74.1 billion to its balance sheet.
In late January the Open Market Committee voted to lower purchases in February by another $10 billion. And, the expectation is that, baring "bad news" on the economic front, the Fed will continue to reduce purchases by $10 billion a month until quantitative easing effectively is done.
This "withdrawal" of purchases shook the markets for EM countries currencies and EM countries securities and resulted in a substantial amount of funds leaving these countries and these markets.
The thing is that this reduction in the purchases of securities does not mean that the Federal Reserve is not continuing to inject funds into the banking system. It is still injecting them at a rate that some of us still feel is excessive.
But, the financial markets work off of expectations and if the market "expects" $85 billion in reserves to be pumped into the banking system every month, then a reduction of $10 billion is a "tightening" of monetary policy.
Quite a few economists who argue that the reduction in purchases is not a tightening at all, of course, have rejected this rationale. In the view of these analysts, the car that was going at 85 miles per hour is still going 75 hours an hour and that is "fast"!
But, tell that to the car that is following the lead car going 85 miles an hour and slows down to 75 miles an hour. If the following car expects the lead car to go 85 miles an hour, the reduction in speed is definitely a "slow down" and if the following car doesn't step on the breaks and slow down as well, then problems will occur.
And, this seems to be part of the problem that the United States has with some of the EM countries. While the Federal Reserve was pumping $85 billion into the banking system every month, foreign countries were taking advantage of the liquidity flowing into world markets and not getting their own acts in order. They apparently believed … as many governments do … that the day will never arrive when the liquidity dries up.
Just ten days ago I reported that reserve balances at the Federal Reserve increased by $881 billion in the previous 52 weeks. Cash balances at commercial banks in the United States rose by almost the same amount, $874 billion. Of this $874 billion increase, 42 percent of the increase went to foreign-related financial institutions. And, of this increase in assets at these foreign-related institutions, a full 75 percent, or about $275 ended up in net due to related foreign offices.
That is, from January 2013 through January 2014, almost 33 percent of the funds the Federal Reserve injected into the banking system went "off shore"!
The liquidity was sorely needed in the European banking system. As for the EM countries, the liquidity was taken advantage of with very little government efforts to correct the imbalances that existed within their systems.
Furthermore, as these countries took advantage of the liquidity that the United States was pouring into world markets, some of them actually complained that the way the United States was providing liquidity to the world was actually doing them harm at the same time. While Brazil was living it up accepting lots and lots of funds into their securities they criticized the Federal Reserve for conducting a policy that resulted in a strengthening of the Brazilian Real and thereby hurting Brazilian exports. They wanted it both ways!
The "fragile five"… and others … had their time.
If Mr. Rajan wants to cry, then the United States should have been crying when India used international liquidity to its own advantage without correcting the imbalances that existed within its economy. Seems to me that international monetary co-operation broke down at that time as well.
To me, the United States has to say to these EM countries … you had your time and you didn't use it well. Now, the United States must do what it has to do … attempt to return to some kind of monetary normality.
Returning to some kind of monetary normality in the United States is going to be difficult enough as it is. At some time in the future, all the liquidity pumped into the economic system is going to have to be dealt with. Right now, the liquidity is not going to fund real economic activity…if it is going anywhere it is just going to finance financial transactions and is staying out of the "real" economic circuit. This channeling in the "financial" circuit causes its own problems, but some day, the United States is going to have to deal with the fact that there is a tremendous amount of money in the system and we don't know how or when this "liquidity" is going to get out of control.
Janet Yellen and the Federal Reserve, I believe, have a massive task facing them in the next four or five years. Beginning the "tapering" is only a first step.
EM countries will be moaning and groaning during this G20 conference. Unfortunately for them, the world has to move on and they will just have to catch up as well as they can. Let the crying begin!
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. (More...)
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