Business Columns & Blogs

Ed Lotterman: Changes in Fed policy hurt some small economies

Several “emerging market” countries are in economic trouble. In all cases, this is not news, yet it seems to have taken Wall Street by surprise.

The values of the currencies of Argentina, Ukraine and Turkey, relative to major currencies like the U.S. dollar, all dropped sharply at the end of January, and a 2 percentage point dip in U.S. stock indexes followed.

In turn, the mild trend toward slightly tighter monetary policy by the Federal Reserve, which continued at its last policy meeting, is being blamed for the economic difficulties of emerging markets in general and for declines in the exchange values of their currencies in particular.

Just what is going on? Is the long-expected reduction in the rate that the Fed increases the U.S. monetary base really that powerful? And should problems in countries that account for only a minor slice of total global output really depress the value of publicly traded corporations on Wall Street by billions of dollars?

Let's start with the short answers to these questions. Yes, changes in United States or Eurozone interest-rate policies can disrupt the economies of smaller countries, particularly those that are heavily indebted or those in which international trade is large compared with their overall economies. But when a poorer country experiences a sudden change in the value of its currency in foreign exchange markets, such as Turkey and Argentina have had in recent days, it usually is a reflection of underlying domestic economic and political problems that have been growing for months or years.

Now for the details, starting with the Fed. In response to the financial debacle that began to unfold in the second half of 2007, our central bank implemented an unprecedented expansion of the total bank reserves that underpin the U.S. money supply.

Despite the fact that economic theory says too-rapid rises in the money supply cause inflation, this has not happened at consumer or producer levels in the U.S. because banks have not lent aggressively. But that in turn has left a glut of liquidity sloshing around financial markets. These markets aggressively have sought opportunities to put this cash to work earning a return even slightly higher than in domestic loans or investments.

And there's the connection.

The economies of several emerging-market countries seemed to present such opportunities. Brazil had enjoyed more than a decade of stable growth after decades of inflation. Argentina was growing rapidly after a financial crisis in 2002. And both benefited from high commodity prices driven by Chinese demand. Turkey, under Prime Minister Tayyip Erdogan, seemed to be transforming into a modern economy, and so on.

But as large as the economies of Brazil and Turkey may be, the total amount of capital bouncing around in search of a home was larger -- certainly so relative to Argentina and Ukraine and other third-tier nations.

To buy stocks or bonds in any of these countries or to make loans to their domestic companies and households, you need to trade dollars or euros for the local currency. The more money offered to buy the local currency, the more it rises in value relative to the major currencies being tendered.

To the economically illiterate, such strengthening of currency is good news, a source of pride. But when one unit of a nation's money is worth more dollars, it means that the nation's exports are more expensive to foreign buyers and that imported goods are cheaper relative to those produced domestically. It is good for consumers but bad for producers, for GDP growth and for employment.

Thus, only three years ago, Brazil's finance minister was complaining that his country and other emerging markets were victims of "currency wars" waged by the Fed, the European Central Bank, the Bank of Japan and the central bank of China. Excessive inflows of capital were harming their economies.

Now, as the overall U.S. economy shows signs of strengthening and as U.S. interest rates are slated to rise, even if only marginally, money generally is flowing in the other direction.

Moreover, where political problems are acute, such as Turkey and Ukraine, or where years of economic mismanagement are becoming apparent even to the most benighted -- such as in Argentina -- investor panic becomes a factor.

Heretofore complacent investors realize they have taken on more risk than they realized and are out of their league in terms of assessing it. Trying to get out of the door before everyone else does is a natural response.

When more people try to sell the local currency in exchange for dollars or euros, the price of the local currency must fall. That has positive effects on exports and hence on output and employment.

But it also puts upward pressure on prices, since effective foreign competition is depleted, and it becomes more difficult to make principal and interest payments on any public or private loans contracted in the foreign currency. Less money is available for business investment in new plants and equipment or even for consumer purchases.

The negative effects tend to hit immediately; positive ones take longer. And when the country has underlying domestic problems, the upshot can be a sudden, sharp economic crisis.

If a nation's central bank has large reserves of foreign currencies, it can slow a decline in the exchange value of its own currency by selling off reserves to meet demand. Argentina has been doing so.

But this can continue only as long as there are reserves. Reserves in Argentina and Ukraine are melting fast with speculators taking positions that will pay off once the inevitable devaluation takes place. This can speed up the process.

The only sure way to bolster a currency's value is to raise domestic interest rates, thus luring back foreign capital. But this puts the brakes on the domestic economy. Nevertheless, Turkey's central bank did so earlier this week and many other emerging market nations will have to do so sooner or later.

So yes, actions by the U.S. fed can influence the economies of myriad other nations, who are correct in complaining that they suffer whiplash on both ends of U.S. monetary policy swings. But well-managed and politically stable economies, such as those of Chile or Uruguay or Taiwan, are not suffering the same harsh fluctuations as those of Argentina, Ukraine, Turkey or Thailand, where either economic mismanagement is deep and political problems severe.

This all is just beginning. Expect emerging market economic problems to be in the news a lot over the next couple of years. But this does not necessarily mean a global crisis.