Yellen or Summers: who’s the better Fed chief for emerging markets?

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The leader of the global monetary cycle will profoundly shape investor sentiment towards emerging market assets – with Janet Yellen seen as a dovish boost for markets – given the structural link between US policy rates and foreign ownership of the local government debt stock. But the master-slave relationship of yesteryear is over.

To many observers in the US, guessing who president Barack Obama will pick as the next chairman of the US Federal Reserve has become something of a summer holiday diversion. But to policymakers and investors in emerging markets, it’s a serious question, not a frivolous popularity contest. With Ben Bernanke’s tenure in charge of the world’s most powerful central bank due to expire in January 2014, the two leading candidates to succeed him are understood to be Janet Yellen, currently vice-chair of the Fed and a respected economist, and Larry Summers, a brilliant economist who has served in influential posts both domestically and at the World Bank. Although the final decision will be Obama's, emerging markets experts face an agonizing wait. Maarten Jan Bakkum, head of emerging markets strategy at ING investment management, said: “From an investor perspective, the most important thing to bear in mind is that emerging markets gain in terms of capital from accommodative policies, so on that basis Yellen would be the favourite because she is seen as less aggressive in scaling back quantitative easing.”
The appointment matters because Bernanke’s decisions control the fortunes of emerging markets much more than their own monetary authorities. The emerging markets carry trade has been a staple feature of the post-crisis financial markets, with investors dipping into the unlimited pile of risk-free cheap funding from the Fed and ploughing it into higher-yielding emerging markets. These markets have benefited from big inflows, and the announcement in May by Bernanke that the Fed was considering scaling back or tapering quantitative easing in the light of an improving US economy prompted the MSCI emerging stock index to plunge by 3.3%, hitting its lowest level since July 2012. A clumsy exit from QE could have disastrous consequences for emerging markets. Despite the resolute pitch from emerging market fixed-income portfolio managers that EMs can decouple from the Western credit cycle, the Fed leads the global rates party, with US government yields directly shaping local government yield curves in emerging markets. To wit, a January 2013 research paper by the Federal Reserve Bank of New York found a “10-basis-point reduction in long-term US Treasury yields results in a 0.4-percentage-point increase in the foreign ownership share of emerging market debt,” in turn reducing local government yields by 1.7%, across the board. Of course, the relationship between US monetary stimulus and emerging market yields varies according to access to bond markets, strength of the domestic investor base, local monetary policies and the FX regime, among other factors, but the implication of the NY Fed study is clear: the pace of withdrawal of monetary stimulus in the US could directly affect foreign ownership of the emerging market local debt stock, analysts say, with Yellen offering EM fixed-income bulls more hope. If Yellen’s a shoo-in for investors, policymakers and politicians in emerging markets may have a different view if capital flows rebound. Brazilian finance minister Guido Mantega has been among those to cry foul of Bernanke’s accommodative approach, which hits exports and triggers currency wars as capital inflows create asset bubbles. Last October, Yellen rounded on Mantega and his other critics at a seminar in Tokyo during the IMF’s annual meeting, saying, although “interest-rate differentials”played a role in driving capital flows to emerging economies, investor appetite for risk and exposure to growing economies largely accounts for the strong demand for emerging market assets. She added: “On balance, stronger US growth [thanks to a loose US monetary stimulus] is beneficial for the entire global economy.” She concluded: “Interest rate differentials do drive capital flows and [this] undoubtedly puts pressure on exchange rates [but] it is not the Fed’s intention to make things more difficult.” Despite their gripes, emerging markets policymakers would probably rather stick with the status quo, in the shape of Yellen – who is likely to advocate a gradual tapering of QE in the mould of Bernanke – over Summers, who has expressed doubts about the effectiveness of quantitative easing and might move to halt asset purchases earlier. Bakkum adds: “Certainly, emerging markets receiving a lot of capital has a big impact on their interest rates and credit growth and the whole emerging world is sensitive to that.But the countries that are most vulnerable to the slowdown in QE are those that have big current account imbalances or imbalances that are growing quickly. They are South Africa, Brazil, Turkey, India and Indonesia.” Aside from her dovish view and her status as the candidate for continuity, there is another factor in Yellen’s favour – Summers’ track record in emerging markets. During the 1990s, when he was at the World Bank, Summers and US Treasury secretary Robert Rubin forced through austerity measures on tens of millions of Asians during the region’s financial crisis. Bakkum added: “From a policymaker’s perspective, they are more likely to want a person who has diplomatic skills to deal on a global scale. Yellen may be the slight favorite on that too as Summers is a bit of an unknown quantity.” That said, his experience in dealing with crises might work in his favour. An inelegant end to QE could have damaging consequences for emerging markets, but the reported policy differences between Yellen and Summers might be overstated. In any case, the Fed also provides global intellectual leadership on central banks’ mandates and global financial imbalances. But the master-slave relationship – emerging market central banks following the Fed’s guide – is over. Whether it is touting the virtues of capital account liberalization, making exhortations to snub fiscal pressure to monetize deficits, or calling for purely market-driven exchange rates or greater vigilance to curb financial excess, the Fed’s credibility, from the perspective of emerging market policymakers, is not what it used to be. Meanwhile, the growth of a stable institutional investor base to buttress local yield curves and the ability of emerging market central banks to decouple from the Fed policy cycle – hiking rates amid inflationary pressure even as the Fed cut post-Lehman – means emerging markets are increasingly coming of age.

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