Federal Reserve "Tapering" News and Emerging Markets

...stronger emerging markets on average were affected more negatively by tapering news than their weaker counterparts.

In The Transmission of Federal Reserve Tapering News to Emerging Financial Markets (NBER Working Paper No. 19980), Joshua Aizenman, Mahir Binici, and Michael Hutchison find substantial declines in emerging-market stock prices and exchange rates in response to news announcements -- tapering news -- suggesting that the Federal Reserve Board would reduce its monthly purchases of long-term Treasury bonds and mortgage-backed securities in the years following the recent U.S. recession.

The authors analyze daily data spanning the period from November 2012 through October 2013. They examine the impact of statements by Federal Reserve officials on emerging-market stock prices, exchange rates, and credit default swap spreads. They exploit the heterogeneity among the emerging markets to estimate the association between market reactions and country characteristics that pertain to financial strength or weakness, such as the current account balance and international reserve and foreign indebtedness positions. The researchers divide emerging markets into two groups: 11 countries with robust fundamentals and 16 with fragile fundamentals. They find that the stronger emerging markets were affected more negatively on average by tapering news than their weaker counterparts. News that raised the probability of tapering was associated with large stock market declines and an increase in the sovereign spreads of the stronger group. By contrast, tapering news had an insignificant impact on spreads and stock markets in the weaker group. The exchange rate depreciated for both groups of countries following news that increased the likelihood of tapering. Currency depreciations were on average three times larger for the strong than for the weak countries. These results demonstrate that in an era of financial globalization, emerging-market financial markets are not insulated from expected changes in Fed policy. The authors also find evidence that asset prices responded more to statements by Federal Reserve Chairman Ben Bernanke than to statements by other Fed officials.

The researchers interpret their finding that stronger emerging markets were hurt more by tapering news than were their weaker counterparts as suggesting that financial market participants were not placing much weight on the longer-run implications of tapering for the weaker countries, and that they were more concerned with near-term balance sheet adjustments that might affect the stronger countries.

-- Matt Nesvisky