The ‘fragile five’ and the Taper Tantrum

The large scale bond purchase program (aka Quantitative Easing) started by the Federal Reserve in 2008 was an unprecedented move in the history of central banking. In the run up to the financial meltdown, the Federal Reserve Bank had increased the Federal Funds Rate to around 5% and started reducing the rate gradually when the crisis heightened in 2008. However, the policy rate reached its zero lower bound (the infamous ‘ZLB’ ) in 2009 and could not be reduced further to stimulate the economy.

FFR

As the markets panicked after the failure of the banking giant Lehman Brothers, the Federal Reserve Chairman, Ben Bernanke and Treasury Secretary, Henery M. Paulson Jr. presented their 700 billion dollar ‘rescue plan’ to the the Congressional leaders. These funds were going to be used to buy equity in troubled banks and to buy sub-prime mortgage backed securities which nobody was willing to buy. This was just the tip of the ice berg since the Federal Reserve eventually expanded its Balance sheet by more than 2 trillion dollars between 2008 and 2013. Such a massive inflow of liquidity ( purchase of long term government bonds and mortgage backed securities) lowered the yield on 10 year government bonds and investors flocked to emerging markets in search of higher yields. There were concerns among the policy makers that such a massive influx of capital can be destabilizing for the emerging market economies,especially if the investors pull out their money should the US begin to taper the asset purchases. The first announcement about tapering(reducing the amount of bond purchases) was made following the Federal Open Market Committee (FOMC) meeting on May 01, 2013 in which Ben Bernanke said that the pace of asset purchase would be reduced if the economic recovery is sustained. The minutes of the meeting were released on May 22, 2013 and financial markets in the emerging markets reacted sharply to the announcement. There were remarks made about tapering in the subsequent FOMC meetings and the in the FOMC meeting of December, 2013, it was announced that the Fed will reduce its bond purchases from $85 billion a month to $75 billion a month. This event can be considered as the actual tapering event. I conducted a simple event study analysis for select emerging market economies to see how the financial markets reacted to these tapering announcements and I want to share the simple yet instructive graphs that I have for the response of exchange rates and bond yields in these countries.

In August 2013, a research analyst at Morgan Stanley coined the term – ‘Fragile Five’ to refer to the emerging market economies, which had been affected severely by the tapering talks and were likely to be affected the most should the US begin to raise interest rates. India was one of the ‘Fragile Five’ along with Brazil, Turkey, Indonesia and South Africa. While India’s real economy was relatively unscathed by the crisis, its financial sector showed little resilience. Following the FOMC announcement of tapering (reduction in the amount of bond purchase by the Fed), the cumulative loss in INR/USD exchange rate between May 2013 and September 2013 was of the order of 14 percentage points.

I conducted the event study exercise for the fragile five and analyze the reaction of  exchange rates and bond yields in these countries. For the event study analysis, I conducted the following regression:

Δy_{m-1,m+1} = α + Β D_{m}

where the dependent variable is the change in the target variable (exchange rate and bond yields)  in a one day window before and after the event. One day window makes sure that we can isolate the effect of the event in question because no other event is likely to have happened in such a short window. D_{m} is the dummy variable for the event, which takes a value equal to 1 on the event date and zero other wise. I had 16 dummy variables for 8 FOMC meetings and 8 FOMC minutes in 2013 and I used daily data on exchange rates and bond yields.

The following figure graphs the exchange rate of the Fragile Five vs the US dollar from January 2013 to March 2014. The data is taken from Bloomberg. Increase in the exchange rate is depreciation. The exchange rate for 02 Jan, 2013 is normalized to 100. The vertical lines represent the FOMC dates which had a significant impact (using event study analysis) on exchange rates. The last vertical line – Dec 18, 2013 was not significant but is plotted to illustrate the actual tapering event.

ERgraph

We can see from the figure that all currencies started depreciating following May 01 FOMC. The depreciation for South Africa was particularly steep. In the next FOMC, on June 19, 2013 Ben Bernanke further reinforced the possibility of tapering. He said- “if the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.” Following the June FOMC, markets reacted again and currencies depreciated further across the board. It can be seen form the graph that the increase was highest for India. Rupee reached a low of 68 to a dollar in August 2013. It is interesting to note that the actual tapering started in December 2013 when the Fed announced its plan to reduce its bond purchases from $85 billion a month to $75 billion a month however markets reacted very mildly to this announcement since they had already incorporated the information on FED’s intent to taper during the previous FOMCs. This event was found to be significant in the event study analysis.  A similar story appears when we look at the yield data on 5 year government bonds and 10 year government bonds. The following figure plots the 5 year government bond yield for the Fragile Five. Bond yields on Jan 01, 2013 are normalized to 100. The vertical lines represent the FOMC dates which were found to have a significant impact on bond yields ( except for Dec 18, 2013)

BondYield5Yr

From January 2013 to May 2013, the bond yields on the 5 year government bonds were quite stable. Following the taper announcement in May 2013, the bond yields begin to rise as investors start pulling out their money from emerging markets as they anticipate higher return on US government bonds. Bond yields rise persistently from May 2013 to September 2013 and by December 2013, bond yields have risen by 50% on an average. Bond yields for 10 year bonds also exhibit a similar pattern.

Janet Yellen suggested on Friday, May 22, 2015 that  “an interest rate hike will be appropriate this year if the US economy improves”. It is highly likely that there will be a massive sell off of emerging market currencies if the US raises its interest rates and the emerging markets should brace themselves for a rate hike. India may have been the worst hit in the taper tantrum of 2013 but the recent efforts by the governor of RBI, Raghuram Rajan to accumulate forex reserves will make sure that India is not severely affected by volatile capital flows. India is no longer a member of the Fragile Five, it is replaced by Mexico. Hopefully, the rate hike, if it happens in the near future, will not cause immense distress to the financial sector.