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Taper Trouble
July 26, 2014, 12:17 pm
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In April 2013, Ukraine was sporting a massive current account deficit of eight percent, and it badly needed dollars to pay for vital imports. Yet on 10 April, President Viktor Yanukovych’s government rejected terms set by the International Monetary Fund (IMF) for a $15 billion financial assistance package, choosing instead to continue financing the gap between its domestic production and its much higher consumption by borrowing dollars privately from abroad. So a week later, Kiev issued a ten-year, $1.25 billion eurobond, which cash-flush foreign investors gobbled up at a 7.5 percent yield.

Everything seemed to be going swimmingly, until May 22, when the US Federal Reserve’s then chair, Ben Bernanke, suggested that the Fed might, if the US economy continued improving, soon begin to pare back, or “taper,” its monthly purchases of US Treasury and mortgage-backed securities. Their end would mean higher yields on longer-maturity US bonds, making developing markets decidedly less attractive.

Investors in Ukrainian bonds therefore reacted savagely to the taper talk, dumping them. Yanukovych ultimately turned for help to Moscow, which successfully demanded that he abandon an association agreement with the European Union in return. Ukrainians took to the streets -- and the rest is history.

Ukraine was only one of many developing nations suffering massive selloffs in their bond and currency markets, as investors sought to repatriate funds for safer investments in the United States. The selling was not indiscriminate, however. The countries hit hardest -- Brazil, India, Indonesia, South Africa, and Turkey -- had all been running large current account deficits, which needed to be financed with imported capital. Their markets recovered modestly following the Fed’s unexpected decision in September to delay the taper but faltered again in December when the Fed announced that it would move forward with its plans.

The US dollar plays a unique role in the global economy. Although the United States accounts for only 23 percent of global economic output, most of the world’s trade outside the eurozone and 60 percent of foreign exchange reserves are denominated in US dollars. Particularly for developing countries, economic interaction with the rest of the world takes place overwhelmingly in US dollars.

Changes in US monetary policy can therefore have immediate and significant global effects, expanding or constricting the flow of capital into and out of developing nations and whipsawing the value of their currencies against the dollar, which can in turn dramatically alter local inflation rates and export volumes.

As markets tanked, many leaders of the worst-hit countries criticized Washington for its selfishness and tunnel vision. But just as the Fed was criticized for causing foreign currencies to plunge with its taper talk in 2013, so had it been condemned for doing the opposite, causing foreign currencies to spike by initiating quantitative easing, in 2010. Many countries’ export competitiveness was hurt as a result.
Yet expecting the Fed to act otherwise, however desirable it might have been for other countries, was unrealistic: the Fed’s primary objectives -- ensuring domestic price stability and maximum employment -- are set by law, and the Fed is not authorized to subordinate them to foreign concerns. Unsurprisingly, it has not shown any inclination to do so since the financial crisis erupted six years ago.

The US Federal Reserve was created a century ago to end domestic banking panics. The devastation wreaked on British finances by two world wars elevated the Fed above the Bank of England to its current, privileged role at the center of the global monetary system. But even as the power of the Fed increased, it never adopted the same sense of global stewardship as its British counterpart had in the nineteenth century. The US Congress has never shown any desire to change this, and it is hard to imagine it changing its mind anytime soon.

It is easy to see why other governments have begun looking for an alternative to the current dollar-dominated global financial architecture -- one in which US monetary policy would be less disruptive abroad.  Developing countries can take actions on their own to protect themselves, without cooperation from the United States.

A recent study published by the IMF concluded that countries whose economies have been more resilient in the face of unconventional US monetary policy since 2010 have three characteristics: low foreign ownership of domestic assets, a trade surplus, and large foreign exchange reserves. This has clear policy implications: in good times, emerging-market governments should keep their countries’ imports and currencies down and their exports and dollar reserves up.

Unfortunately, many in the United States see such policies as unfair currency manipulation, harming US exporters. To prevent foreign governments from taking such steps, some influential American economists have called on the White House to insert provisions against currency manipulation into future trade agreements. Such suggestions are misguided; they would only raise global trade tensions and political conflict. But the very fact that prominent commentators are calling for these actions illustrates how the functioning, or malfunctioning, of the global financial and monetary system can encourage a spiral of damaging policy actions.

As the ongoing crisis in Ukraine suggests, nasty financial crises tend to become even worse political ones -- and the world is likely to see plenty of both in the years ahead.

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