Emerging markets are at risk of revisiting last year’s “Bernanke shock” should the Federal Reserve signal an end to near-zero interest rates earlier than investors anticipate, according to Takatoshi Kato, once a deputy managing director at the International Monetary Fund.
Former Fed Chairman Ben S. Bernanke triggered a rout across emerging-market assets when he raised in May last year the possibility that policymakers could reduce the pace of record bond buying. His successor, Janet Yellen, started tapering those asset purchases in 2014 and has been saying the benchmark interest rate will remain low for a “considerable time” after the quantitative easing ends. She is scheduled to deliver a speech this week at the annual gathering of central bankers in Jackson Hole, Wyoming.
“Because the scope of monetary stimulus globally has become so large, potential repercussions are all the more significant,” Kato, who also worked as a top currency official at the Finance Ministry and is now the president of Japan’s Center for International Finance, said in an interview in Tokyo last Wednesday. “It will require immense energy to unwind those capital outflows.”
The Fed is on track to end tapering by year-end after reducing monthly buying of Treasurys and mortgage-backed securities by $10 billion for a sixth consecutive meeting last month to $25 billion. In March, the central bank abandoned a pledge to keep rates “exceptionally low” as long as the jobless rate was above 6.5 percent to instead say it will take into account “a wide range of information” on labor markets and inflation.
“Forward guidance by the Fed has made their policy outlook more predictable,” Kato said. “I doubt Yellen will say anything definitive at Jackson Hole. The opinions among members of the policy board seem quite divided.”
Futures traders see a greater than 70 percent chance the Fed will raise its benchmark interest rate to at least 0.5 percent by October next year.
The MSCI Emerging Markets Index of shares is up 7.2 percent this year through the end of last week, after plunging 5 percent in 2013. A Bloomberg gauge tracking 20 emerging-market currencies has fallen 0.8 percent since Dec. 31, extending last year’s 7.2 percent drop.
The yen traded at 102.40 per dollar as of 8:30 a.m. Monday in Tokyo, up 2.8 percent this year. The currency weakened 18 percent in 2013, the sharpest annual drop since 1979.
Japan posted a current account deficit of ¥399.1 billion in June, Finance Ministry data showed Aug. 8. The shortfall in the unadjusted current account is the first since January and the deficit for the first half widened to ¥508 billion, compared with ¥79 billion in the second half of 2013.
The nation’s external position and exchange rate are “broadly in line with the fundamentals over the medium term,” International Monetary Fund First Deputy Managing Director David Lipton said on May 30.
“Japan’s current-account surplus has been taken for granted, as if it will continue forever,” Kato said. “While the IMF’s assessment is that the current level of the yen is appropriate, that level may change over time if the current-account deficit continues.”
Prime Minister Shinzo Abe is urging the ¥126.6 trillion Government Pension Investment Fund to alter its asset mix and buy more stocks and foreign assets.
The world’s largest pool of retirement savings will pare domestic bonds to 40 percent of holdings and boost local stocks to 20 percent, according to the median estimate from a Bloomberg survey of analysts in May. That would require selling ¥19.5 trillion of bonds, calculations by Bloomberg using the fund’s holdings at the end of March show.
“It’s desirable for GPIF to diversify its portfolio, but safety also has to be taken into consideration,” Kato said. “Marginal investments into emerging markets are acceptable, but because these markets are smaller and more volatile, the core of foreign investments should be in developed nations,” Kato said.
The shift to foreign assets will weaken the yen, though it’s hard to say to what extent, he said.
Kato served at the Finance Ministry for three decades and held jobs including vice finance minister for international affairs, the No. 1 currency position. He was the IMF’s deputy managing director for six years until 2010.