January 2014 was the first month since November 2008 that the Federal Reserve did not expand their balance sheet. Indeed, in January, the Fed reduced the size of its monthly asset purchase programme by $ 10 billion from $ 85 billion to $75 billion . The immediate impact has been a depreciation of Emerging Market currencies. An index by Bloomberg tracking 20 emerging market currencies has declined to 90.14, the lowest level since April 2009 . Indeed, both the World Bank and the IMF have anticipated slower Emerging Market growth and improved performance in developed countries. What then will the impact be on Kenya's economy? This is a difficult question as there are a number of moving variables that will determine the impact, if any, at all. Nonetheless, a piece of research from a group of World Bank economists provides some answers. The research focuses on the impact QE has had on developing countries and further analyses some "what-if" scenarios that Tapering will have. The research shows that QE has led to an increase of three per cent of capital inflows into developing countries over and above the levels that would have prevailed without quantitative easing (QE). This has primarily worked through three channels: the portfolio channel, liquidity channel and confidence channel. The portfolio channel works through a re-balancing of investor portfolios in essence; QE reduces the supply of safe assets (bonds) and causes investors to turn towards riskier alternatives. The liquidity channel increases the amount of liquidity as banks exchange bonds in return for cash thereby increasing system-wide liquidity and hence lowering rates. Lastly, since QE is accompanied by credible guidance from the Central Bank , investors feel more confident and hence are willing to take more risks. These effects have been evident in the last four years. Rwanda's debut bond was oversubscribed almost 10 times despite the country's lack of a stable export orientation. Ecuador which defaulted on a $3.2 billion bond in 2008 is in the market for international debt. Moreover, in 2012, there was a record amount of Eurobond issuance from African countries. This shows that clearly, investors re-adjusted their portfolios in preference for riskier assets. The World Bank study makes the distinction between Foreign Direct Investment (FDI), loan flows and portfolio inflows. Portfolio inflows are further divided into equity and bond inflows. The research as expected finds that FDI is the most stable source of funding. On loan and portfolio inflows, the researchers find these are rather volatile. In fact, loan and portfolio inflows tend to respond to "global push" factors rather than "pull" factors. This simply means that domestic factors are less important to attracting loan and portfolio inflows as opposed to "push" factors such as QE or donor country money supply growth. The researchers finally forecast a decline of financial inflows into developing countries of four per cent in 2014 and a cumulative decline of 10 per cent by 2016. This has significant implications for Kenya and particularly the stock market. Recent regulatory filings show, for instance, that foreign investors have increased their holdings in Equity Bank and Uchumi . Moreover, the stock market has crossed the Sh2 trillion mark largely on the support of foreign investors. As the World Bank research has shown, portfolio investment of this nature is the most volatile since it is based on "push" factors rather than "pull" factors. Going forward, there is a significant risk of a sudden stop that would lead to a market correction and a depreciation of the currency. Indeed, Kenya's capital account attests to this. Short-term capital inflows account for more than 50 per cent of total financial inflows. To mitigate the risks of a sudden-stop, industrial policy needs to change to ensure that FDI accounts for the majority of total financial inflows into the country. There is an eerie similarity to what is going on now and what happened in the early '70s where the break-down of the Gold-Standard led to a significant increase in capital inflows to developing countries. The implications were the 1980s debt crisis and resultant IMF structural adjustment programmed (SAPs) that destroyed a number of economies.
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