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In May 2013, Ben Bernanke’s hint of ’tapering’ or slowing down the pace of the Federal Reserve’s unconventional monetary policy called Quantitative Easing (QE) caused nothing short of turmoil within emerging market economies (EMEs). Rapid outflow of capital and a concomitant deterioration of current account deficit resulted in sharp depreciation of currencies and an overall worsening of the respective domestic macroeconomies. By September 2013, the Indian rupee and the Brazilian real had fallen by more than 15 percent each. Inequity markets, Indonesia’s Jakarta Composite Index and Turkey’s BIST 100 shed nearly 20 percent each during this period

The QE program created $85 billion per month via asset purchases and expanded the Fed balance sheet four times from $1 trillion in 2007 to $4 trillion currently. This scale of liquidity was accompanied by near zero interest rates. Although QE was aimed at facilitation of a domestic recovery in the US following the global financial crisis, it also prompted investors to direct capital into EMEs to reap better return. Once these investors sensed a reversal of US monetary policy, they retracted their investment and collectively caused a capital flight from the EMEs.

Unconventional monetary policies to ensure cheap liquidity and easy credit conditions have not been limited to the US. Japan embarked on its own version of QE to pull its economy out of a deflationary trap; in Europe, the ECB introduced negative deposit rates to motivate bank lending. It can well be argued that this highly accommodative monetary stance of central banks in advanced economies has led to demand augmentation and aided global recovery.

According to the IMF, global growth is expected to strengthen from 3 per cent in 2013 to 3.9 per cent in 2015. Out of this, AEs are expected to grow at about 2.25 per cent in 2015 - a full percentage point greater than the growth rate in 2013. The positive growth in the advanced economies has, in turn, helped create external demand for EMEs, which are also expected to register an increase in growth.

On deeper analysis, however, it is obvious that the recovery is sluggish at best. Investment to GDP ratios are below the pre-crisis levels and productivity continues its declining trend. Instead of capacity building, firms have preferred to buy back shares and engage in mergers and acquisitions. Indeed, capital expenditure fell by one per cent last year with the decline more severe in EMEs.

Given the underlying data and low economic output, economists have warned of ’secular stagnation’ - a permanently lower trend of growth. Although unconventional monetary policy has induced positive growth rates, it has failed to correct structural problems. What’s worse is that the prolonged prevalence of low interest rates has become a source of global imbalance.

Bubbles and spillovers

In its latest annual report, the BIS referred to a "puzzling disconnect" between the euphoria in global financial markets and real economic developments. Recent data on high valuations on equities, rising property prices and depressed yields on bonds implythat investors are on a ’search for yield’. The S&P 500 gained almost 20 per cent in the year to May, whereas expected future earnings grew less than 8 per cent over the same period. Similarly, property prices in the UK were up 10.5 per cent in the year to May. There is also a fear that low interest rates have facilitated the creation of a global bond bubble - since 2009, USD 1.2 trillion has flowed into global bond funds. Importantly, sales of ’junk’ bonds - high yield, high risk bonds - touched a quarterly record of USD 148 billion between April and June that at times, depressed yields to less than 5 per cent in that period. Narrowing risk premiums and escalating asset prices without real improvement in inherent fundamentals show how the global financial system has become so dependent on easy monetary policy.

Spillovers from unconventional monetary policy in the AEs pose a systemic risk for EMEs. In order to stem the capital flight last year, central banks in EMEs were forced to raise interest rates and intervene in currency markets mostly at the expense of economic growth and an erosion of foreign exchange reserves. In fact, since then efforts to rebuild foreign exchange reserves have intensified to prevent recurrence of sudden capital outflow. These reserves perpetuate a savings glut, chiefly denominated in US debt and divert resources away from productive investments within EMEs themselves.

In central banks we trust

Low real output and global imbalances in a zero interest rate context have made central banks the vanguard of the world economy. If they raise interest rates too quickly, a downward spiral in asset prices could occur and possibly escalate to another financial crisis. If they delay, investors will continue to misprice risk and feed subprime asset bubbles. Indeed, Sweden’s central bank, Sveriges Riksbank dabbled with the former only to see the economy sucked into a deflationary trap.

Interest rates, if at all, must be deployed with sufficient ’forward guidance’ and clear communication so as to prevent investor panic. For instance, central banks in the US and UK have targeted a threshold rate of inflation and employment before any hike inthe nominal interest rates. Macroprudential measures such as property taxes and restrictions on excessive leverage can also help to control bubbles.

In as much as the scenario within EMEs impacts the global economy, central banks must look beyond their own domestic mandate. Before recalibration of monetary policy, careful consideration must be placed on long term implications on the EMEs. However, the buck does not just stop with the AE central banks. EMEs themselves must look to strengthen international safety nets - the announcement of a Contingent Reserve Arrangement (CRA) at the latest BRICS summit that pledges $100 billion of mutual support is a case in point. In a world with swifter cross-border flows, lack of macroeconomic coordination may come at an exorbitant cost. This can be avoided.

Manmath Goel
19 August 2014
(Manmath Goel is a Research Assistant at Observer Research Foundation, New Delhi)

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