ECONOMICS: The taper effect

The Federal Reserve bond-buying programme has supported investment in emerging markets. Andrew Short asks how the start of tapering in January might affect them and Brazil, in particular.

It’s on.
It’s off.
It’s September…
… or maybe some time in 2014.

The commencement of the scale-back of the US Federal Reserve’s monthly $85 billion dollar asset purchase programme, known as QE3, has been the main driver of the markets in late 2013. The mere hint of tapering – which is now to start in January 2014   –has had investors in Brazil on tenterhooks, as the asset purchase programme has increased capital flows into emerging markets.

Since May, when the Fed first announced it may start to taper, there have been capital outflows from emerging economies, and this sparked a downward spiral in the Brazilian real – taking stocks and bonds with it. This levelled off slightly in August when the Brazilian Central Bank intervened to stabilise the currency.

But in September, the Fed surprised even the most nervous of emerging market economies by deferring the taper.

With strong job creation and low employment in the US, the tapering wolf is now banging loudly at the door. The US economy added 203,000 jobs in November, the Labour Department reported, and the unemployment rate also fell to 7% – the lowest level in five years. GDP came in stronger than expected, too. Third quarter real GDP increased at a rate of 3.6%, up from the initial estimate of 2.8%.

But is Brazil really all that vulnerable to Federal Reserve tapering, or is it just short-term noise and scaremongering? To answer the question one needs to look at the perceived effect on Brazil, and how it has benefited from US asset purchases.

Many of the positive effects of asset purchases coincided with other factors to bring about a golden time for the emerging markets, according to Joaquim Levy, the chief executive officer of Bradesco Asset Management (Bram). “This was coupled with a relaxation in monetary policy interest rates in the US and Europe, and was happening as negative perceptions about developing markets were rife,” he says. “This is in contrast to the medium term potential of emerging markets and it increased the attractiveness of investing in these countries. The relaxation of rates and expanded liquidity, of course, brought about a very unusual situation.”

Low rates in the developed world shifted investment values to a hunt for yield. Todd Henry, T Rowe Price emerging markets portfolio specialist, says: “This has resulted in significant inflows into emerging markets fixed income [for higher yields] and into emerging markets equities for the last several years.”

However, for Alexander Ball, managing director at VN AM, a specialist regional investor and based in São Paulo, the reality is that Brazil has not benefited due to quantitative easing or the implications of Federal Reserve asset purchases.

“If you look at emerging market stock performance and compare these markets to the FTSE 100, Nikkei and S&P 500, Brazil has underperformed with a large divergence since 2011, and this has been in the wake of quantitative easing.”

Ball adds that money has also flowed out of emerging markets and consistently into  G7 economies. “This appears to be a medium-term trend – so is Brazil vulnerable to tapering? Maybe short-term, but the reality is that it is not a major driver, in my opinion. The lack of structural reform on a macro and corporate level during a cyclical upturn is more relevant than external central bank asset purchases. If Brazil performs well economically, [tapering] will be irrelevant.”

Furthermore, as 2014 moves along other events will overshadow the taper. This is a big year for Brazil: there is a presidential election and the Fifa Football World Cup. Election years are spending years: city, state and federal projects are timed to peak in the months before votes. The period overlaps with the World Cup, another giant spending event.

However, there has been an increasing chorus of criticism nationally and internationally that the Brazilian government has run out of ideas. Investor scepticism also lingers on a sense of policy drift owing to the political imperatives with the upcoming elections and difficulties authorities faced in getting high profile projects off the ground. This negative image may also curb the foreign investment the government would like to keep flowing into the country.

Brazil’s current account deficit is mainly funded by foreign capital and its current image could damage these lines of investment. Financial markets are concerned with the direction of movement, especially a steady deterioration of fiscal accounts.

It has been included into a group of countries known as the fragile five (Brazil, India, Indonesia, Turkey and South Africa), emerging countries running very high current account deficits that will be hurt by tapering.
However, Brazil is in a better position than these because the central bank has a relatively large pile of currency reserves, high real interest rates, and a current-account deficit largely financed by the foreign direct investment it would like to keep flowing in.

The inclusion of Brazil in the group of countries affected by high current account deficits suggests that the analysis of vulnerability must go deeper than external financing constraints.

Given Brazil’s historical sensitivity to changes in US monetary conditions, the fear of Fed tapering among market participants looms large with regard to the strengthening dollar off the back of a US recovery.

In a research note published by Itau Global connections, SLJ Macro Partners managing partner, Stephen Jen wrote the simple answer is that, until the taper has well and truly begun, the effect of the process will not be known.

However, it is certain that the real will fall against the dollar, he says, “as has been the case since May when the Fed started tapering talk”.

During other periods of turmoil when the real has fallen, it has recovered losses – but according to Jen it is unlikely the Brazilian currency will return to previous levels. He adds: “One reason is that terms of trade – the differences between export and import prices – which benefited the country between 2004 and 2010 thanks to the boom in China, are not so favourable.”

This fall in the real has materialised. Leaving no stone unturned to shore up the currency, the Brazilian central bank stepped in aggressively to dent the sharp depreciation and counter attack imported inflation.
In August 2013, Brazil also announced a $60 billion currency intervention programme involving swaps and repurchase agreements with businesses requiring dollars.

However, a higher dollar is not all doom and gloom, as was visible in earnings reports for June to September. A weak Brazilian real helps operating profitability of Brazil’s steel mills, pulp exporters, paper companies, iron-ore miners, meat processors, and ethanol and petrochemical refiners, as well as multinationals.

Some analysts have said emerging markets would do better shoring up their economies than pinning their hopes on the Fed’s ability to avoid market disruptions. Emerging nations are better prepared than in the past, but they still need reforms to strengthen their economies.

A decade of high commodity prices, rising global liquidity and rapid growth that brought dozens of millions of poor out of poverty bolstered the finances and economies of many nations. However, those engines of the global economy have lost steam in the last few years as structural reforms to relax labour laws and bring in long-term investment have lagged.

“It’s good to have some pressure on emerging market nations to do their own homework,” says Goldman Sachs chief Latin America economist Alberto Ramos. “They must find endogenous sources of growth rather than just ride the global wave of high liquidity.”

This is exactly what tapering could provide for Brazil and may be a positive pressure according to Bram chief economist Fernando Honorato Barbosa.

“The effect of tapering increases the need for Brazil to accelerate the refurbishment and expansion of its infrastructure – notably in transportation,” he says. “This type of positive supply shock will help Brazil to brace for the challenges that tapering will bring to capital flows.”

Before the recent announcement of tapering, some were warning of the consequences of the Fed delaying its action. Without reforms many emerging economies could get burned.

For example, Itau Unibanco chief economist Ilan Goldfajn, said: “If [tapering is] later and faster, it could be tricky for emerging market nations.”

However, long-term prospects for Brazil remain attractive and, as a result, funds are expected to flow back.

Finally, with the Fed making it clear that its actions will be governed by US interests only, tapering could be the trigger for Brazil to forge ahead with the critical reforms it needs to restore economic confidence.

©2013 funds global latam



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