When Yellen said in February that the Fed would continue its tapering policy, emerging markets took a big hit. Investors began to flee from the more risky emerging market economies back towards the US. The flow of capital out of the emerging markets led to their currencies weakening and many central banks having to step in to stabilize currencies by raising interest rates. Turkey, Brazil, South Africa were some of the countries that were hit hard by the capital flight. The economic downturn that emerging markets saw is not something new. Throughout history, tighter monetary policy usually leads to economic struggles in emerging markets. The Asian, Latin American, Mexican crisis all were in response to the Fed rising interest rates. When the US has lower interest rates, emerging markets can borrow more because of the lower cost to finance their debt. Once US interest rates rise, or the Fed tightens monetary policy, it becomes more expensive for emerging markets to maintain their level of debt. The lower US interest rates also forced investors to search for higher yields which also contributed to the movement of capital to emerging markets. Two months later, the question becomes, which emerging markets were hurt the most by the Fed tapering.
A recent article by the Wall Street Journal analyzed the publishing of a recent paper by the National Bureau of Economic Research. The paper found that it was the strong emerging market economies that were harmed the most by the Fed’s tapering announcement. When I read this, at first I was surprised. But as I thought about it more, it made more sense that stronger emerging markets would lose capital the most. When investors were looking for higher yields, it would make sense that they would head to the economies with the next strongest fundamentals. The NBER paper, written by Hutchinson, Binici and Aizenman, believes that emerging market economies with current account surpluses, high international reserves and low external debt were the ones that had the most flight of capital when the Fed announced tapering. I believe that it was these strong fundamentals which were the reason why investors decided to send capital to the emerging markets. The movement of capital to these emerging markets strengthened their currencies against the dollar and when the Fed announced tapering, it led to a large exchange rate depreciation. I’m not surprised that the countries that attracted the most investment, because they was the next safest alternatives, lost capital the fastest. The easier that capital flows, the more likely it will return to the safest option when that options yield increases.