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All eyes on Yellen, as global markets brace for reversal in US monetary policy

Days of volatility ahead for world economy.

Janet Yellen. Credit:
Janet Yellen. Photo via

By Krishnakumar S.

NEW DELHI: As the world awaits Janet Yellen’s decision relating to an interest rate hike in June, speculation is rife in the international financial markets that Fed’s unconventional monetary policy, pursued since the crisis, is all set to be reversed.

The dollar index reached to a 12-year high a week ago, with dollar appreciating sharply against the euro. The favorable growth numbers in United States in the last quarter and better numbers projected in the coming quarter, coupled with the decrease in unemployment numbers, has given credence to this speculation of an interest rate hike. Indeed the dollar index has been appreciating for over more than six months now, at a pace not witnessed since 1976.

Even as the United States is readying to reverse its monetary policy, on the other side of the Atlantic, in the light of the growing unemployment, and in the context of the Greek tragedy, European Central Bank President Mario Draghi has already began his $1.1 trillion program of bond purchases. Japan, too, is continuing with its bond purchases as well as the fiscal expansion through Abenomics to somehow get Japan out of the stagnation, which it has been going through over the last two decades.

Similarly, responding to the domestic economic conditions, emerging market economies from China to India, as well as economies from Sweden to Singapore, have all been favoring reduction in interest rates.

No wonder, as interest rates worldwide are largely being reduced, in response to the unfavorable domestic economic conditions, when interest rates are speculated to be hiked in the United States, there has been an unprecedented inflow of funds back to the country.

This is partly due to the unwinding of the carry trades — that is capital which was borrowed cheap in the US to be invested in the emerging market bonds, indeed to benefit from the interest rate differentials. When interest rates elsewhere have already been largely reduced, this tendency of borrowing cheap in the US and investing in the securities of emerging market economies has been showing signs of reversal.

The corporate bond market of the emerging market economies, amounting to $12 trillion, has been witness to huge mobilization of funds in the last few years. Even when two-thirds of the same are denominated in dollars, given that global liquidity was in search of opportunities for investment, countries ranging from China to India, and Brazil to South Korea, were even able to mobilize part of their funds from the international market in local currencies.

Concerns which were raised then with respect to the consequences of an interest rate hike in the US or the depreciation of the currencies of the EMEs are now turning out to be true, even before we have reached the “bridge of interest rate hike.”

Brazil is an illustration in this regard. It is evident that the huge outflow of capital from Brazil has resulted in the steady deprecation of the real over the last few months, making it the worst performing currency in the world. Running short of reserves to intervene, President Dilma Roussef and her team at the Central Bank of Brazil, whose hands are tied in this regard, are running for cover behind the logic of non-intervention.

Even with high unemployment in the domestic front, in the name of fighting inflation, they are forced to hike their interest rates to 12.25 percent, indeed to stall the capital flight from the country. Brazil’s case is all the more important, for it was its finance minister, who, a few years ago, had raised the alarm of currency wars, when the Fed inspired monetary loosening was resulting in Brazil being inundated with dollar inflows, resulting in the appreciation of the Brazilian real, stifling the competitiveness of its exports.

Similarly severe is the condition of Russia, which was nurturing imperial plans, only to find its fortunes dipping with the fall in price of oil. With huge capital outflows, President Vladimir Putin was found pleading to the billionaires to returns the funds hosted in other countries lest they be frozen.

The cross-border flow of funds to the emerging market economies driven by interest rate differentials is all set to reverse, for as the US is speculated to increase its interest rates, rest of the central bankers of most emerging market economies have already reduced the interest rates, capitulating before  genuine demands of the industry and the growing share of unemployed.

It is to be seen as to how the world economy would respond to the risks associated with this unraveling. As funds are being withdrawn from the $12 trillion strong emerging market bonds, of which at least two-thirds is denominated in dollars, it is to be seen as to how the developing country corporates would be able to shield against balance sheet problems, for a good part of the borrowing has been done in dollars and invested in local currencies.

As the local currencies depreciate, it is only logical that there is all set to be yet another serious macroeconomic crisis which would set in some of these economies, from where there is going to a barrage of outflow. It is to be seen as to whether the dexterity with which the world has responded to the US-Europe crisis would be there when it comes to resolving the imminent emerging market crisis.

Even as the US Dollar Index is appreciating, the current account deficit of the United States is all set to increase. With funds from the world flowing into the US market, the scene is set for the creation of a new bubble. This could result in the United States entering back into that “spend, splurge, import and party” mode, for the buoyant capital account would underwrite the current account deficits.

Through enhanced competiveness facilitated by the depreciation of their currencies, some of them would be able to grow riding this tide. But, with the sort of trade access restrictions being maneuvered by the US Department of Commerce, one is not sure as to which economies would benefit. It seems that Washington is all determined to decide as to who else other than the United States should be the beneficiaries of such a situation. But, the days ahead are sure to be days of volatility in the world economy.

Krishnakumar S. teaches economics at Sri Venkateswara College, University of Delhi.

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