When the butterfly flaps its wings in the US, it seems that it can spark a tornado in emerging markets. The global economy and its free flow of capital ensure that financial contagion can occur in a matter of days, or even seconds. But, the real economy is now secondary to the global system – the only thing that really matters is the flow of capital into and out of financial assets. This imperative is now so important that central bankers have abandoned traditional policy goals in favour of a coordinated move to keep asset prices high.
While this is true in general, it is important to distinguish among different types of central banks. Monetary policy, as a global tool, is only in the hands of a few major central bankers – namely the Fed, the ECB, the BoJ, and the BoE. All others have become mere spectators, watching Bloomberg for the latest news, all the while trying to peg their currencies to the major FX players (dollar or Yen) and in the process suffering the bittersweet consequences of globalisation and free flows of capital.
The last five years were great for emerging markets, as the so called ZIRP (zero interest rate policy) conducted by the Fed in addition to the major asset purchase package helped emerging markets attract new money. Their domestic currencies experienced appreciations and they were able to keep interest rates relatively low; both of which boosted economic growth. But, as became clear last year, the same factors that ignite such capital inflows can reverse them in a matter of days…
With the end of QE (in the U.S) approaching fast now and investors slowly beginning to anticipate rising interest rates, investors are now selling assets in emerging markets and returning to the ‘safety’ of developed markets, something which is exerting downward pressure on equities and currencies in the former. At the same time, currency depreciation will eventually force developing countries to raise interest rates prematurely, as a function of international financial asset movements and not the real economy.
While the free flow of international capital can be highly beneficial when in the form of foreign direct investment, what we have here is hot money flow, its ugly sister, and which is much more fickle. The developed world is so full of debt that at some point it could be enough to put the financial system at risk. What will happen then? Yes, that’s right our friendly Central banks will ride to the rescue again and inject even more liquidity!
Through creating this positive feedback loop, the central bank attracts more and more investors into the market. The system is completely self-fulfilling and so needs no real connection with the actual economy. No matter what happens in the real economy, the equity market seems to go ever higher, as money pumped into the system ensures demand for real assets remains elevated.
Of course, this is a huge Ponzi scheme – and one that will end with the most nefarious consequences ever seen. But while the music’s playing, one might as well get up and dance. Even the “smart money” follows the trend as “the market can stay irrational longer than you can stay solvent”. Nevertheless, this is a vicious game that is destroying the real economy, one that when finally busted will cast us all into the darkness of another Great Depression.
Filipe R Costa