Friday, November 29, 2013

Tapering And What To Do About It

As always in such matters, the answer is: it depends (excerpt; emphasis added):

Should Policy Makers in Emerging Markets be Concerned about “Tapering”?

The US and European economies are showing some signs of recovery from the global financial crisis that began in 2008. As a result, the US Federal Reserve Bank is considering phasing out, or “tapering”, the extraordinary monetary policy measures through which it responded to the crisis…The World Bank's East Asia and Pacific regional update estimated that in East Asia alone $24 billion was withdrawn from equities and $35.2 billion from bonds...Financial markets largely recovered once the Fed decided to postpone tapering in September, but there is still nervousness….

…When investors suddenly withdraw from markets, it has led in the past to macroeconomic crisis manifested as government default on debt, a recession, hyperinflation or some combination of these....However, many of the earlier crises occurred in countries with fixed exchange rates or significant foreign exchange denominated debt. Paul Krugman has written a new paper arguing that in countries with floating exchange rates and low levels of external debt, the risks are low. The key, noted earlier by Paul De Graawe is that countries that borrow in their own currency have a lender of last resort - the central bank can always buy bonds and so the risks of default are lowered. A floating exchange rate provides a mechanism for macroeconomic imbalances to adjust, relieving the pressure on interest rates or wages….

...So should policy makers be concerned about tapering? For countries with floating exchange rates, low inflation and limited foreign currency borrowing, the risks to the real economy (as opposed to financial markets) should be limited. Policy makers should let the exchange rate depreciate rather than raise interest rates. Policy makers in countries where these conditions are not met and have significant foreign investors in debt or equity markets will have to use interest rate adjustments and macro prudential measures to manage capital flight. For all emerging market countries, the larger risk might be if the Fed and ECB unwound their extra-ordinary measures prematurely.

In Malaysia’s case – floating exchange rate, low inflation, fairly low external debt – the policy response to tapering should be the same as the title of that Beatle’s song: let it be.

We’ve got high foreign ownership in both bond and equity markets, but there’s also significant domestic capacity to absorb a foreign sell-off: EPF, PNB, KWAP, and other public investment institutions (combined assets of more than RM900b), plus a banking and insurance industry hungry for yield. That will limit any damage from lower asset prices and/or higher long term interest rates. I’d see any such foreign retreat as a good time to enter the market, because it makes investment cheaper relative to long term valuations.

Downward pressure on the Ringgit boosts export competitiveness, although any improvement here would be limited by the “structural surplus” inherent from being part of a regional supply chain. Nevertheless, damage to financial markets should be more than offset by improvement in the real economy.

As the article says, the biggest risk isn’t tapering per se, but a pull back in policy measures before the advanced economies are back on their feet.

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