05/14/2014 05:44 EDT | Updated 07/15/2014 05:59 EDT

The Politics of Monetary Tightening

When it comes to elections, timing is critical. This year brings a rash of elections in some of the most important emerging markets: Brazil, India, Indonesia, Turkey and South Africa are all going to the polls in 2014. These also happen to be members of the "fragile five" countries most vulnerable to the ongoing withdrawal of quantitative easing. Does this clash of events spell political turmoil for these key economies? And what of countries already saddled with social unrest? Should we expect that the wave of protest activity will continue to expand its reach?

Last year at this time, the Fed's 'tapering' announcement created instant turbulence across emerging markets. Almost a year later, tapering is in full swing, and emerging market bourses, bond spreads and currencies continue to gyrate, marking an end for these markets of an ultra-cheap-credit era. While the focus in the media has been largely on the financial and economic impact of the tapering, there is also the potential of political fallout. Is a popular backlash likely to occur, or do we see the current political season coming and going without unusual incidents?

As taper-talk began last year, EDC Economics developed a country vulnerability ranking, based on post-crisis portfolio flows, bank credit growth and average current account balances. If some countries are more likely to experience financial shocks, are they just as likely to see internal political turmoil? To gauge this, we added a number of inward-looking indicators to the country vulnerability list.

First, and perhaps foremost, is the Misery Index (the inflation rate added to the unemployment rate). We looked at countries with scores above the 15% threshold, and then added other factors: the change in currency, interest and growth rates over the past year as well as the World Economic Forum's indicators on institutions and macro-economic environment. Effectively, those markets already experiencing such economic stress are most susceptible to a rise in popular discontent stemming from a tougher financial environment. Against these metrics, Turkey and Ukraine showed the highest vulnerabilities, followed by India, Argentina, the Dominican Republic, Indonesia and Brazil.

Discontent on its own is rarely what leads to popular protests. Rather it is a complex mix of external and personal factors which determine whether an individual goes to the street to express their grievances. That being said, rising interest rates, diminished purchasing power and growing unemployment can exacerbate existing tensions. It's clear that with slower growth and tighter budgets, competition for fewer resources may lead to more conflict within society.

This is especially true for the large segments of the population which are at the lower end of the middle class and who for the first time have been enjoying an improving standard of living. As the gates of free flowing credit begin to close, so too may the sources of this neo-wealth. This, coupled with the mounting structural constraints of emerging markets such as infrastructure bottlenecks, could further exacerbate the vulnerable political conditions in markets like Brazil.

The gradual withdrawal of quantitative easing will perhaps reveal two divergent paths for emerging markets. Some will see the tightening of liquidity as a wake-up call to implement needed structural reforms, and be rewarded for it (like Mexico). Other governments may well struggle, blaming markets or falling back on the crutch of increased nationalism and trade protectionism. As borrowing costs rise, populists will no doubt come under pressure as they will have less room to spend.

The bottom line? The effects of winding up quantitative easing are likely to exacerbate existing social discontent while threatening to initiate it in especially vulnerable markets. With a total of 44 elections taking place in emerging markets this year, 2014 is shaping up to be a pivot-point for the choice of policy-path. It's certainly a year to keep a close eye on global politics

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