The Fed Can't Be Blamed for Emerging Markets' Woes

Policymakers in developing nations have blamed the Federal Reserve's "tapering" plans for the turmoil in emerging markets last year. Indeed, shortly after the Fed announced its intentions to gradually draw down its quantitative easing program, currencies and equities in emerging markets such as India, South Africa, and Brazil plunged. Is the Fed's tapering really responsible for these sell-offs?

Emerging-market turmoil
The excess liquidity in the financial system due to the Fed's bond purchases was mopped up by emerging markets over the last few years. Investors brushed aside fundamentals as they poured money into these hotbeds of economic growth. However, when the Fed announced tapering plans, investors began exiting markets that were fundamentally weak. Currencies and equities in several emerging markets subsequently fell sharply last year. Yet the real reason for this sell-off is not Fed tapering, but rather poor economic conditions and policymaking in these developing nations.

Policymakers to be blamed
Most of the emerging markets that saw a sell-off last year had high current account deficits. In fact, Morgan Stanley last year coined a term called "fragile five" to describe the economies of India, South Africa, Brazil, Turkey, and Indonesia. All of these countries were vulnerable due to their excessive reliance on foreign capital to fund their current account deficits. Because investors were looking for higher returns during the easy-money era, they ignored the weak fundamentals of these economies and poured money into them. The system worked fine so long as there was excess liquidity, but as soon as the Fed announced tapering plans, that money began to flow out of the fundamentally weak emerging markets -- the "fragile five" were hit the hardest.

Brazil's problems
Brazil's IBOVESPA index has been one of the worst performers among the emerging markets in the past year, falling 8.4%. The index fell sharply in late May last year after the Fed first announced tapering plans. However, the sell-off was coming regardless, as Brazil's economic growth had slowed significantly and inflation was too high.

In fact, ratings agency Standard & Poor's has recently slashed the credit rating on Brazil's long-term bond to just one notch above junk. The ratings agency cited weak economic growth prospects, rising debt, and a widening government deficit as the reasons for the downgrade. According to S&P, these factors have weakened the Brazilian government's ability to cope with external shocks.

Brazil's poor policymaking has taken a toll not only on the economy but also on oil and gas giant Petrobras (NYSE: PBR  ) . Only a few years ago, Petrobras was expected to become one of the biggest oil and gas companies in the world thanks to Brazil's vast offshore oil reserves. However, Brazil's energy policy, under which Petrobras is forced to subsidize fuel, has hurt the company's financial performance. At the same time, the company has failed to boost its production. The result is that Petrobras is now the world's most indebted oil and gas company. The company's shares have now fallen more than 18% in the past year.

India's policy woes
India's economic growth, like Brazil's, has slowed considerably in the past two years. The country has high current account and fiscal deficits, although the country's current account deficit narrowed recently. The result has been a weakening economy with stubbornly high inflation and weak consumer sentiment.

In 2013, annual car sales in India fell for the first time in 11 years, dropping 10%. More importantly, the slowdown is expected to continue in the first half of 2014. This is bad news for Indian automaker Tata Motors (NYSE: TTM  ) .

In February, the company had reported a 35.7% drop in the sales of its commercial and passenger vehicle sales for the quarter ended Dec. 31, 2013. The company noted that a prolonged slowdown in economic activity and weak consumer sentiment continued to impact the auto industry.

Poor policymaking has also damaged the investment climate in India. Excessive regulations on foreign investment forced U.S. retail giant Wal-Mart Stores (NYSE: WMT  ) to end its joint venture in India last year. India's expanding middle class makes an attractive opportunity for foreign retailers like Wal-Mart, and the country recently opened the retail sector to foreign investment. Even now, however, strict regulations -- for example, a law requiring that retailers source 30% of products locally -- have made several retailers hesitant to enter India.

Don't blame the Fed
The cases of Brazil and India prove that much of the problem in emerging markets has been due to poor policymaking. This is further proven by the recent rally in Indian equity markets. While the Fed has continued its tapering, Indian equity markets have risen to record-high levels. The rally in Indian markets owes to expectations that next month's election will bring a change in government and policymaking, which could boost economic growth.

Emerging-market nations can't rightly blame the Fed for their recent travails -- and some have no one to blame but themselves.

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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