With the US central bank poised to embark on another round of money-printing, there are growing fears about the tsunami of hot money that’s about to flood into emerging markets, fuelling massive asset price bubbles.
Some countries have tried to temper foreign capital inflows. For instance, in the past month, Brazil has tripled the tax on foreign investment in Brazilian bonds and closed a series of loopholes in the tax.
But many, including Andy Xie, the former Morgan Stanley chief Asian economist, worry that such efforts are unlikely to be enough to prevent the huge distortions caused by massive capital inflows.
In his latest article on Caixin Online, Xie argues that the turmoil in global currency markets is largely due to the huge US reliance on monetary stimulus to revive the flailing economy. And, with next week’s mid-term elections likely to result in political gridlock, there is likely to be increasing pressure on the US central bank to engage in another round of quantitative easing (dubbed QE2), which involves printing even more money, and buying more US government bonds.
Xie argues that QE2 will be largely ineffective in boosting US consumer spending, or increasing investment by US companies. But it does have a big impact on currency markets.
When the Fed buys, say, $500 billion of US government bonds, the previous owners of the bonds get the same amount in cash.
“Where does the money go next? More cash should lead to currency depreciation. Hence, it makes sense to sell dollars and buy foreign currencies. The lower dollar would increase the prices of risk assets like commodities and emerging market stocks. Hence, it makes sense to go into these assets too.”
Xie argues that hedge funds anticipate these moves, and borrow funds in advance to buy the assets they expect other investors will eventually buy. That’s why the prices of these assets are moving higher even before the Fed implements QE2.
According to Xie, when foreign investors start buying up the assets of an emerging country – such as bonds – the country’s currency moves higher, while its interest rates drop. The higher currency suppresses inflation, which justifies lower interest rates for a while. Lower interest rates fuel a rise in stock and property prices, sparking more investment. And the large capital inflows into the country make it easy to fund this higher investment. At the same time, higher asset prices create a wealth effect, encouraging people to consume more. For a while, he says, “the whole picture looks quite rosy”.
The trouble arrives when the liquidity suddenly dries up. Then, plunging property and share prices can wreak havoc on the economy. Emerging markets went through this destructive cycle in the 1990s, which culminated in the Asian financial crisis of the late 1990s.
According to Xie, “What’s occurring now is similar to what occurred in 1992-97 but on a much larger scale. The Fed kept monetary policy eased to cope with a banking crisis. As liquidity flowed into emerging economies, their stock markets were caught in a swell. The rising domestic liquidity led to rising property prices.
“The high stock and property prices led to a lot of fund raising and investment. The economies grew rapidly. We know now that the prosperity was a bubble. The investment boom was due to funds availability, not better future earnings outlook. Inflation, another consequence of the liquidity, boosted corporate earnings in the short term, covering up the consequences of over-investment in the short term. When the liquidity began to recede, the house of cards came apart.”
With the prospect of even more US money-printing in the months ahead, Xie urges emerging countries to move quickly to curb hot money inflows.
“Forget about free market dogma. This is literally a life-and-death situation. In three months, the market may start to talk about QE3 by the Fed. The hot money will likely double or triple from here.”
What’s more, he says, emerging economies should push up interest rates decisively to cool inflation and asset bubbles.
“The latter is suicide. It nearly killed the emerging economies a decade ago. They may not survive the next time.”
And, he says, if there are any doubts as to how painful it can be when asset bubbles burst, look no further than the current situation in the United States, the United Kingdom, Spain, Greece and Ireland.
This article first appeared on Business Spectator
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