Monday, September 6, 2021

My latest Mint column, on how dollar hegemony threatens emerging markets, revising the old Triffin Paradox.

As the last instalment of this column observed (“The dangers of continuing with unconventional policies”, 20 August), there is a rising drumbeat of debate about the unwinding of US “unconventional monetary policies” — in particular, large scale asset purchases, more commonly called “quantitative easing” — as well as the eventual normalization of the policy interest rate to above the near-zero level at which it has been stuck since the global financial crisis.

The topic came up for discussion during the recent (virtual) Jackson Hole meeting of the US Federal Reserve, where Fed chief, Jerome Powell, sent the markets his strongest signals yet that the US central banks is preparing to wind down its asset purchases, at present a staggering $120 billion per month. In a much-watched speech, Powell asserted that “substantial further progress” has been made on the Fed’s twin goals of keeping inflation on a low and stable path and the economy moving closer to full employment.

The minutes of  a recent Federal Open Mark Committee (FOMC) meeting, which sets Fed policy, and which met before the Jackson Hole event, suggests a broad-based consensus amongst committee members that QE should start winding down later this year, although it is expected that the Fed will continue to hold an elevated stock of bonds even as the inflow of additional purchases tapers and eventually comes to a stop.

It is noteworthy that, in Powell’s remarks, he sharply distinguished the tapering of QE from interest rate normalization, noting that a much more “stringent test ” would apply to the latter operation. The significance of this important distinction should not be passed over lightly.

Readers will recall well the 2013 “taper tantrum” crisis, on which your columnist has dilated on, and which created a panic in global financial markets — especially, emerging economy stock, bond, and currency markets — after then Fed chief, Ben Bernanke, rather loosely remarked that the Fed was planning to begin dialling down its asset purchases, without being terribly clear on his likely forward guidance on a glide path for interest rate normalization.

Speaking on the possibility of Fed tapering in an interview to the Financial Times (“Emerging economies cannot afford ‘taper tantrum’ repeat, says IMF’s Gopinath”, 29 August), International Monetary Fund chief economist, Indian-born, American economist Gita Gopinath, warned that emerging economies could not “afford” a repetition of the 2013 taper crisis. She told the FT: “[Emerging markets] are facing much harder headwinds….They are getting hit in many different ways, which is why they just cannot afford a situation where you have some sort of a tantrum of financial markets originating from the major central banks.”

The danger that Gopinath and others have pointed out is that higher or stickier than expected inflation in the US will  likely prompt the Fed to more aggressively ramp up interest rates as part of an accelerated normalization of monetary policy.

The danger scenario for emerging economies, especially heavily indebted ones, would be the twin blows of rising debt service costs on their dollar-denominated debts as well as the likely outflow of a large quantum of capital funds enticed by the now higher returns to be earned in dollars, to say nothing of the safe haven value of the dollar in times of economic volatility. Indeed, this is exactly what spooked the markets, and hobbled many key emerging economies, including India, back in 2013.

If such a “double whammy” scenario, as Gopinath terms it, returns today on the back of Fed tightening, the IMF estimates that $4.5 trillion of global gross domestic product could be wiped out by 2025. What is worse, the hit will likely falling disproportionately on low income developing and middle income emerging economies, according to former IMF chief economist, Maurice Obstfeld, also speaking to the FT. The fact that these economic shock waves would emanate in the context of a pandemic crisis that is worsening in many parts of the still largely un-vaccinated developing world might just make this the perfect storm.

In an unusually candid (as well as rather canny) comment, Gopinath observed that one of the difficulties at the time of Bernanke’s 2013 remarks that touched off the taper crisis was his announcement on QE tapering got “mixed up” with market expectation of more rapid interest rate normalization. This confusion may, indeed, have abetted the seriousness of the 2013 crisis, as it created greater uncertainty, with many more “carry trade” and other speculative investors in the emerging markets bolting for the door at the same time. She noted that, this time around, “super clear communication” is the need of the hour, and suggested that Powell is doing a good job. The implied criticism of Bernanke’s poor communication in 2013 is the understated inference.

Some perspective may be useful. As I noted in one of my earliest columns in this newspaper (“Illusions bred by a reserve currency”, 17 July 2014), reliance on a single global reserve currency, the US dollar — whether de jure, under Bretton Woods, or de facto, as at present — creates a peculiar dilemma, noted in the 1960s by economist Robert Triffin: the short term, domestically driven goals of the reserve currency economy may diverge from long term needs of the global economy. Inevitably, the hegemonic large country, which provides the reserve currency as a global public good, will privilege itself, at the expense of the rest of the world. The “Triffin paradox” is still with us.

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