Why the Fed is not worried by emerging market moves

By Paul Donovan
February 14, 2014

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Several emerging market central banks have been forced to react to market events already this year. Interest rate increases in India, Turkey and South Africa followed bond or currency market volatility. Argentina has endured dramatic moves in its currency, and Brazil has been forced to tighten policy.

The moves in these markets, unlike those of 1997-1998, do not suggest a systemic threat to all emerging markets. Investors have distinguished markets where errors in fiscal policy, monetary policy or political risk created a fundamental mispricing. Such errors are generally most visible in a current account deficit or a government budget deficit, or both.

The prospect of rising global bond yields has offered investors alternative investment opportunities to these troubled countries, with fewer risks. Countries that have followed a more orthodox policy approach, and have generous foreign exchange reserves and current account surpluses or equilibrium have been less threatened.

Some policymakers have sought to either blame U.S. Federal Reserve policy or to suggest that the Federal Reserve should in some way consider the needs of emerging markets in its policy settings. Leaving aside the illegality of this (the Federal Reserve is required by law to consider domestic inflation and domestic unemployment, and nothing else), the Fed has little incentive to worry about the indirect consequences of its actions. The United States is not particularly exposed to the emerging markets.

The question of “exposure” is not as simple to answer as one might suppose. If Germany exports components to Turkey that are used to assemble products which Turkey sells in France, does Germany care about domestic Turkish demand? Of course not; Germany’s concern is with the health of final demand in the French economy and Turkish final demand is incidental. German components are being sold to France, albeit via a rather circuitous route.

This means that straightforward trade exposure (in the sense of “country A exports x percent of GDP to country B”) does not tell us anything about the actual exposure of one country to another. To get the real exposure we have to use the trade in value added data that is provided by the OECD and the World Trade Organisation. What these figures show is a relatively limited level of exposure to the troubled emerging markets.

(GRAPHIC: Country exposure to the six volatile emerging markets. Trade in value added as percentage of GDP. Source: OECD TiVA database, UBS)

Looking at the combined value added exposure to Turkey, India, South Africa, Russia, Brazil and Argentina, there is very little sense that problems in these economies could be transmitted to the developed world by trade links. The importance of trade links depends, of course, both on the importance of trade overall to an economy and then the tendency of these specific countries to demand goods and services for their domestic consumption. The United States trade in value added that ended up in these six economies amounted to some 0.73 percent of U.S. GDP.

This is not a large sum — marginally more than U.S. trade with the UK in terms of importance, and somewhat less important than trade with France and Germany combined. Even if the six emerging markets were to see a 10 percent drop in their domestic demand (a horrifically large number) this would amount to less than 0.1 percent direct impact on U.S. GDP.

It is a similar story in Europe. Germany has trade in value added with these six economies amounting to 2.04 percent of its GDP. That basically puts these six economies combined on the same level of importance as France, when it comes to the German economy. The UK’s exposure is 1.25 percent of its GDP, France 1.12 percent of GDP. In Japan, exposure is a mere 0.69 percent of GDP, making it the least exposed economy in the world.

Generally speaking, those economies that care about developments in the six weaker emerging markets are those that are either raw material exporters (which is not a surprise as emerging markets tend to be commodity intensive importers) or which have geographic proximity. Of the major developed economies, Switzerland is among the more exposed — but this is via its domestic tourism business and via financial intermediation.

Swiss exposure might therefore be considered dependent not on the overall demand of the emerging market economies, but on the demands of the rich in those societies (who either travel to Switzerland, or use their banks).

The Swiss example reminds us that banking systems can expose developed economies to emerging market fallout. However, if developed economy central banks are confident that their banks have managed the risks of exposure, they are unlikely to be deterred from tightening quantitative or monetary policy if domestic economic conditions warrant it.

That some emerging markets are paying a delayed price for past policy error is not something that the U.S. Federal Reserve is going to be too concerned about, and the true “exposure” of the U.S. economy to the emerging markets in difficulties appears to be little more than a rounding error in terms of the likely impact on U.S. GDP.

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