Turbulent Markets

19

Author: William Pottenger

I believe there are three notable aspects of the global economy at the moment: emerging markets, the anxiety leading up to the United States Federal Reserve’s interest rate decision and China’s slowdown. In my previous blog posts, I discussed the latter two topics. In this post, I will not only discuss the former issue but also how the three topics are interrelated.

Emerging markets are the economies of developing countries, which are on track to become rich countries (e.g. Vietnam, Brazil, Mexico etc.). Just like the U.S. and other developed countries, many emerging markets allow foreign investors to purchase their government debt. This market is also known as the high-yield bond market, which has experienced a steep decline in recent months. A significant risk comes with greater upside potential and is at least part of the reason for the drop-off. However, there is a more complicated story behind this market volatility.

In rich countries, policy makers engage in quantitative easing to buy back government shares with capital reserves. These funds allow a country to fight spikes in interest rates by selling their accumulated assets. According to a report from The Economist, global reserves currently stand at around $12 trillion. However, the outflows from countries such as China, Russia and Saudi Arabia have depleted global reserves by around $500 billion. Smaller countries with fewer reserves, and less control over monetary policy, are more susceptible to short-term capital movements (e.g. portfolio rebalancing).

For instance, a money manager may see that the Federal Reserve is about to raise interest rates. Consequently, the money manager adjusts her investment strategy and moves a portion her portfolio from the emerging debt market to the U.S.’s equities. If this particular portfolio was significantly large, this movement could disrupt the emerging market’s policy decisions. Large amounts of capital sloshing in and out of developing countries has been distressing these financial markets.

To compensate for unpredictable foreign investment, some countries, like China, utilize different forms of capital controls. China — in response to the tumbling yuan — stemmed the outflow of cash, using its immense political power to control investment. Other developing countries, which do not have an iron grip control of politics and the economy, could consider market caps. By creating a minimum and maximum allowance for foreign investment the central bank would, in my opinion, eliminate some systemic risk. Furthermore, if the market did go outside of the reasonable range, policy makers would be better prepared to deal with extreme circumstances.

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