x Abu Dhabi, UAEThursday 18 January 2018

Steady hand needed at till as QE2 launches

Another round of quantitative easing could ease pressure, but cheap credit can be dangerous.

Emerging markets are left to brace themselves during the second round of quantitative easing.
Emerging markets are left to brace themselves during the second round of quantitative easing.

Are we witnessing a return to beggar-thy-neighbour economics? The thought arises when one considers the latest round of quantitative easing embarked upon this month by the US Federal Reserve. The move, given the overly regal acronym "QE2", was of course couched in purely domestic terms by the Fed. The US economy remains delicately poised, runs the argument, and a re-inflation of asset markets would give consumers the necessary confidence to start spending again (and just in time for Christmas, too).

There can be little doubt, however, that fresh quantitative easing also represents a moment of US monetary unilateralism. In the absence of a concerted policy by the Chinese government to strengthen the yuan against the dollar, the US authorities have decided to weaken the greenback instead. It is merely an interesting peccadillo of the US system that such an important policy decision, with potentially far-reaching consequences for the global economy, should be taken by unelected economists and passed off (for political reasons) as being entirely innocuous.

Emerging markets, however, are left to batten down the hatches again, as the stately progress of the good ship QE2 leaves in its wake a surge of dollars seeking out higher rates of return. As if anticipating the fresh flood of money, emerging market inflows were already swelling last month, and only slowed towards the end of the month thanks to the approach of the US mid-term elections. The Institute of International Finance expects emerging market capital inflows to hit US$270 billion (Dh991.65bn) for this year, and as much again next year. The growing flood is already prompting retaliation, with some emerging markets, such as Brazil and Thailand, enacting punitive fiscal measures on government bonds in a bid to keep out volatility-inducing hot money.

While the potential for escalation to get out of hand is not yet severe, as Joseph Stiglitz remarked this month - "a currency war will make everybody a loser". Hot money massively increases volatility in emerging markets, while attempts to halt it gum up global trade and shut out efficient allocations of capital in the process. For Mr Stiglitz, the answer is managed exchange rates based on a global reserve of IMF special drawing rights. This, however, is no guarantee against monetary unilateralism (as the rapid breakdown of another managed exchange system, the gold standard, demonstrated in the 1930s). Indeed, the only long-term solution is for each party in the global economy to correctly identify that his own interest lies in maintaining the "rules of the game" for the benefit of all.

However, until and unless that spirit of cooperation returns, emerging markets must remain alert to the dangers of increased volatility.

How does the UAE look set to fare in this new environment? Interestingly, the latest round of easing follows hot on the heels of the recent Dubai World settlement, and an emerging domestic trend of greater resort to fixed-income debt instruments (in contrast to previously popular syndicated bank loans).

As was widely reported at the time, the recent bond issue by the government-related entity (GRE) Dubai Electricity and Water Authority (DEWA) was 6.5 times oversubscribed; but perhaps less commented on was the fact that 84 per cent of buyers were from overseas. A comparison between the yield achieved by DEWA for this offering (6.375 per cent for a six-year issue), and that achieved in April when it became the first Dubai GRE since the Dubai World standstill to issue debt (8.5 per cent for a five-year issue) is enlightening. Essentially, yields for similar instruments from the same company have fallen by a quarter in six months. The successful rescheduling of Dubai World debt during the interim has no doubt played a part in this drop; however, the fact that so much interest originated from outside of the UAE suggests that the more important factor is the abundance of cheap money circulating in emerging markets.

This leaves businesses in the UAE in an interesting position. After the well-documented problems concerning debt in Dubai (which by all accounts originated from too much easy money), one might logically have expected investors to demand a future risk premium for investing in the Emirate - a premium that might even have extended to the other emirates of the UAE. Indeed, such an outcome seemed likely when Moody's Investors Service downgraded several Abu Dhabi GREs in March, despite none being in immediate danger.

Instead of this outcome, however, investor confidence in UAE fixed-income instruments is clearly bullish again. This is good news for many debt-laden companies in the UAE, a number of which must renegotiate big tranches of boom-time borrowing in the coming one or two years. The temptation for them must be to cash in on overseas investor appetite and prepare their own issues for the coming months, in the knowledge that the Fed must one day turn off the dollar tap.

Before the pile-in begins in earnest, however, it may be worthwhile for Dubai especially to heed the lessons of its own recent past, as well as those of the last great global currency crisis, that of the 1930s. In the former, too much exposure to cheap money put the emirate in the front line when the credit crunch arrived. In the latter, it was not the nations that enforced the gold standard that suffered most from its collapse, but rather the middling nations that abided firmly by its rules in the expectation that the maintenance of the system itself provided the greatest security. If Dubai should succumb once more to the temptation of limitless cheap credit, while the UAE Central Bank holds fast to the defence of the dollar, the emirate may well find itself in the uncomfortable position of bystander in a currency war not of its own choosing. For all our sakes, we must hope that QE2 does not sink like the Titanic.