Five years ago, Guido Mantega, then the Brazilian finance minister, warned that the United States seemed to have embarked on an international currency war. Many shared his opinion: when the Federal Reserve introduced its policies of quantitative easing, it weakened the dollar to such an extent that it sparked numerous complaints from emerging markets. Indeed, so much money flooded into countries such as Brazil – and other emerging market destinations – that some governments introduced macro-prudential measures to keep those capital inflows under control.
How times change. These days, investors around the world are once again worrying about foreign exchange volatility. They are also braced for potential upheavals in the world of monetary policy-making. But it’s not the prospect of a weakening dollar and super-loose US interest rate policy that’s causing alarm. In fact, it’s quite the reverse: with the Federal Reserve having signalled that it hopes to raise rates soon, there is growing unease about what a sudden rise in US interest rates might do to emerging markets.
After all, these days capital is no longer flooding into Latin America as it was before; instead, as optimism grows about the strength of the US economy, money has rushed out of places such as Brazil. And that has prompted the Brazilian real to tumble in value by 30% against the dollar in the past year, with significant falls among other Latin American currencies too.
Throwing a super taper tantrum
This poses a host of policy challenges and questions for Latin America. One is how the finance ministries and central banks in the region will cope with the prospect of higher interest rates in the United States. The International Monetary Fund has warned in recent weeks that any move by the Fed could spark a so-called “super taper tantrum” – or a spell of market volatility for emerging market assets that would be even worse than the “taper tantrum” that occurred a year ago when the Fed first started discussing a “tapered” end to its policies.
Some optimists hope this “super taper tantrum” could yet be avoided, if the Fed signals its intentions in advance. Others also hope that Latin America will be better placed than most other emerging markets to weather the storm. But history shows that periods of market volatility have a nasty habit of exposing policy weaknesses.
And what makes any potential “taper tantrum” particularly challenging for policy-makers – and potentially contagious – is that the structure of the financial markets today could amplify any shocks. Most notably, the level of liquidity for trading emerging market assets, such as corporate bonds, has shrivelled dramatically since 2008, when Western broker-dealers were forced to reduce their market-making activities to cope with tougher regulations. This means that any sudden sell-off could potentially cause indiscriminately wild price swings – at least for a period – which could undermine investor confidence.
Too slow to reform
A second big question that hangs over the region, however, is the nature of domestic policies. In the past decade, Latin America was widely praised for the extent of its structural reforms; indeed, one of the key reasons why international investment flows were flooding into the area back in 2010 was that the economies seemed to be posting sustainable growth. However, these days there is rising scepticism about the speed and depth of reforms in countries such as Brazil. Most notably, as the International Monetary Fund has pointed out in recent reports, the pace of structural change appears to have slowed sharply.
In truth, investors were willing to overlook this policy backsliding when the markets were calm – and the region was benefiting from a demand boost from the Chinese economy. But these days, a slowdown in Chinese growth is clearly under way, and the investor mood is becoming less forgiving. In other words, the year to come could be distinctly challenging for some Latin American governments, if they make policy missteps. The key question, then, is whether they have learnt the right lessons from the past – and can make themselves resilient enough to withstand shocks if (or when) the Fed finally acts.
The World Economic Forum on Latin America 2015 takes place in Riviera Maya, Mexico, from 6-8 May.
Author: Gillian Tett is US Managing Editor of the Financial Times
Image: Storm clouds are seen above the city in Sao Paulo January 26, 2010. REUTERS/Mario Miranda.