Strategists point out down side of US monetary policy on emerging markets

News - Banking

Written by Ray Clancy

Thursday, 11 November 2010 10:20

The second round of quantitative easing in the United States is likely to fuel higher inflation in emerging markets and could create asset price bubbles, it is claimed.

‘The divergence between monetary policy activity in the emerging and developed world is growing. While official interest rates are heading higher across emerging market Asia to combat mounting inflation concerns, western policy makers are doing everything they can to support a weak recovery and ward off deflation,’ said Brian Coulton, emerging markets strategist at Legal & General Investment Management.

He outlined why this divergence in policy objectives has intensified long-standing tensions surrounding trade imbalances and exchange rate policies. ‘Asian central banks have been directly intervening in foreign exchange markets, limiting currency appreciation. This has been undermining the relative competitiveness of their trading neighbours in Europe and Japan. As a result of further QE, the US dollar could weaken, further exacerbating this problem,’ he explained.

Coulton believes that emerging markets have been very resilient to the global financial crisis. Private capital flows to emerging markets in Asia as a whole have risen sharply this year as investors seek higher levels of yield and greater potential for capital gain.

‘With capital inflows rising, a stance of no change in exchange rate policy would also require a stepped up pace of foreign exchange reserve purchases and therefore increased scrutiny from trading partners,’ he added.

As a result, a number of emerging economies, Brazil and Colombia for example, have imposed controls on capital inflows in the form of higher taxes or reserve requirements during the past two years, he pointed out. ‘In emerging Asia, tightening efforts are likely to be broader including limiting domestic banks’ short term foreign borrowing and restricting foreign exchange lending to residents. However, the effectiveness of these tightening measures remains uncertain and higher interest rates and faster currency appreciation through the region seem inevitable as inflationary pressures mount,’ he said.

Indeed finance ministers from Brazil, South Korea and Thailand have already said that they are considering measures to counter the US monetary policy decision, fearing the move could add to the flood of foreign funds heading in their direction.

Thailand’s Finance Minister Korn Chatikavanij said neighboring countries and the central bank of Thailand had agreed to ‘impose measures together, if needed, to curb possible speculative money flowing into the region’.

Export oriented emerging nations count on American consumers to buy the goods they produce, but the weaker dollar means their goods will be more expensive in the US, a potential major concern among nations like Japan, Brazil and India.

The financial gains from quantitative easing in the US amounts to ‘fool’s gold’ with short term gains being offset by long term damage, according to financial commentator Edward Chancellor.

Ted Scott, director of UK Strategy at F&C also believes that QE will not succeed in helping the US economy. ‘The first round of QE in early 2009 has been credited with preventing a more severe recession, or even a second Great Depression, although it has failed to create a sustainable recovery or materially reduce the level of US unemployment which is just under 10%,’ he said.

He points out that there is still a lot of scepticism regarding the efficacy of QE, even within the Fed. This could make a second round of QE in Britain less likely, he said. ‘Unlike the US, the UK unemployment rate is much lower at around 6% and there are tentative signs that the economy is still in recovery mode whereas the US economy has clearly stalled in recent months,’ he explained.

‘The UK has also recently announced the details of austerity measures, mainly focused on cuts in public spending, and will want to assess its economic effects before announcing another round of monetary stimulus,’ he added.