Economic update: Tapering fears are hurting emerging markets

Figure 3 – Currencies in emerging markets came under significant stress in May and June

Figure 3 – Currencies in emerging markets came under significant stress in May and June

Fears of future monetary tightening have hit emerging markets

  • The testimony of the Ben Bernanke to Congress in May regarding potential unwinding of current supportive monetary policy framework has had international repercussions, particularly in the currency markets. Figure 3 shows emerging market currencies came under significant pressure with the rupee depreciating by around 8% since early May.
  • The deployment of unconventional monetary policy instruments since 2009 has disproportionately benefited emerging markets. This was because yields on traditionally safe assets like government bonds in advanced economies were pushed to record lows, forcing investors to look elsewhere for return. As a result, capital ‘cascaded down’ the risk spectrum to assets in emerging economies which offered higher expected returns at the expense of higher risks.
  • As economic fundamentals in the US improve, the potential for monetary tightening will increase (see page 3 for further analysis). Low risk financial instruments like government bonds in advanced economies are therefore expected to offer higher yields in future return. This could lead to some ‘on-shoring’ of capital to the US and other advanced economies from the emerging economies, which is already exerting downward pressure on their exchange rates in anticipation of such moves.
  • May and June saw policymakers in several key emerging markets reacting to this development. In Brazil, the government cut taxes on fixed income investments (around 6%) to encourage more capital inflows. The Indonesian central bank increased its benchmark rate by 25 basis points to 6% to prevent the rupiah from sliding further. Meanwhile, the Indian rupee reached an all-time low against the US dollar in June, leaving policymakers with a dilemma: they could increase interest rates to support the rupee but risk chocking-off economic growth.