Why Yellen Isn't Worried About the Emerging Market Crisis

Yesterday, Janet Yellen gave her first presentation to Congress as the Federal Reserve's new Chairman. In it, she said she intends to continue the policies of Former Fed Chair Bernanke. She gave a fairly optimistic report card for the economy, despite the recent weak jobs reports. Surprisingly, Yellen wasn't concerned about last week's sell-off of emerging market currencies. There's little risk, she added, of it leading to another global crisis a la 1998.  Why isn't the Fed worried?

She acknowledged that the Fed's tapering of Quantitative Easingtriggered the sell-off. As the Fed reduces its purchases of U.S. Treasuries, U.S. long-term interest rates will rise. Currency traders now expect a stronger dollar, as interest rates rise. That makes foreign currency look less attractive, especially in countries that are vulnerable to start with. Those countries -- Turkey, Brazil, India, Indonesia and South Africa -- have high current account deficits. This means they need foreign investment to spur economic growth. Without it, they don't have either enough domestic production or demand to keep the wheels running.

The Fed sees that three one-off events: a weaker-than-expected Chinese manufacturing report, the devaluation of the Argentine peso, and Turkey's intervention to support its currency -- triggered the sell-off. This shouldn't spread, but may increase hardships to the vulnerable countries. These were also the countries whos currencies suffered the most: the Argentinean peso, the Turkish lira, the South African rand and the Brazilian real. (Source: WSJ, Janet Yellen Doesn't Mince Words, February 11, 2014)

The Fed's Monetary Policy Report accompanied Yellen's testimony, and it gave more background. It noted that two emerging market countries, Brazil and Turkey, saw their bond yields rise the most after September's FOMC meeting. That's because investors saw them as the most risky. The sell-off occurred as these investors began unwinding their carry trades. That's when that investors had entered into earlier to take advantage of higher EME interest rates than those prevailing in the advanced economies. These trades appeared profitable so long as EME currencies remained stable or were expected to appreciate. But when anticipations of a slowing in the pace of Federal Reserve asset purchases led to higher U.S. interest rates as well as higher market volatility, these trades may have been quickly reversed, engendering sharper declines in EME currencies and asset prices.

How It Affects You

The sell-off in Turkey and Brazil extended to healthier emerging markets, such as the Philippines, Indonesia, and Mexico. However, the healthier countries will recover, while the countries with political instability (Turkey, Ukraine, Thailand) or large current account deficits (Indica, Brazil, Malaysia) will need to make major changes before investors return.

According to Ruchir Sharma, an emerging market fund manager for Morgan Stanley, the best emerging market countries are: China, Czech Republic, Indonesia, Korea, Poland, Sri Lanka, Mexico, and Taiwan. For more, see the summary of his book, Breakout Nations.

via:http://useconomy.about.com/b/2014/02/12/why-yellen-isnt-worried-about-the-emerging-market-crisis.htm