Saturday, November 6, 2010

Emerging Markets and the Federal Reserve

Most investors are by now well aware that the Federal Reserve's QE2 has set sail, to the tune of $600 billion.

In simple terms, the Fed has announced that it will “create” another $600 billion out of thin air with which to purchase a like amount of longer-term Treasury bonds by the middle of next year.

However, there is no truth to the rumor that Ben Bernanke will be writing an updated global version of Dale Carnegie's classic self-help book “How to Win Friends and Influence People”.

Mr. Bernanke's policies may be influencing people on Wall Street, but he is certainly not winning any friends globally. Especially in emerging market countries. The very strong perception there is that the Federal Reserve is trying to export the US woes overseas by printing so many dollars.

The 1997 Asian Crisis...In Reverse

Thanks to the Fed's QE2, there is now even more money sloshing around the global financial system in search of higher returns than available in the US.

What we are seeing right now in the global financial markets are echoes of the 1997 Asian crisis. But in reverse. The economies targeted by speculators are now those that are strong, not ones that are weak.

That period of panic in 1997 saw speculators swamp developing markets with sell orders. Once again today, we see many emerging countries trying to block overseas speculators.

But this time from buying their assets and currencies, not selling them. This is the exact opposite of 1997.

Easy credit policies in the US have further fueled speculation in the currencies of developing economies in strong balance-of-payments positions. And the largest speculative prize of all remains an anticipated upward revaluation of China's renminbi, followed by other Asian currencies.

Emerging Markets Tightening

But the emerging countries are not standing by idly, waiting for the tsunami of US dollars and speculators to devastate their economies. They are taking action.....

The Financial Times calls it QT2. The QT stands for quantitative tightening.

These are measures taken by emerging market countries to counter the effects on their economies of vast capital inflows – that tsunami of Federal Reserve paper.

As the US dollar falls and developing nations see speculators pushing up their exchange rates, more and more countries are discussing stringent restrictions on incoming capital flows. A string of governments in Asia and Latin America have either already implemented, or are considering implementing soon, capital controls to stem the nasty side effects of inflows.

Emerging markets are affected in several ways by the so-called US dollar carry trade. For investors not familiar with what a carry trade is, here is a basic definition. A carry trade can be described simply as when money moves from a low interest rate environment to a higher interest rate environment.

Such speculative inflows contribute little to capital formation or employment. But they do price a country's exporters out of foreign markets. And such inflows can be suddenly reversed if speculators pull out, disrupting trade patterns.

According to a recent research note by HSBC, loose monetary policy in the United States will lead to capital controls across the developing world. In other words, capital controls will follow the weak dollar as inevitably as sunset follows sunrise.

Emerging markets are struggling with what HSBC calls the “impossible trinity”. This is an inability to allow free flows of capital while simultaneously maintaining a grip over interest rates and exchange rates. HSBC went on say “The more the west pursues quantitative easing, the more the emerging world, via capital controls, will pursue quantitative tightening.”

Danger to the US

There is a real long-term threat to the United States from all the Fed's quantitative easing. The danger is that the world breaks into two competing financial blocs. One bloc would still be centered on the dollar. The other bloc centered on the emerging nations. Particularly the large nations such as China, India, Brazil and others.

Tentative steps in that direction already occurred last year. China, India and Russia among others took early steps to use their own currencies for trade, rather than the US dollar.

China took a simpler path last month when it supported a Russian proposal to start using the renminbi and the rouble for trading between the two countries. China has also negotiated similar deals with Brazil and Turkey.

It looks like more and more of the developing countries will be moving down a similar path very soon to protect their own currencies and their economies.....

If these countries do implement such policies, it will have been largely due to US policy short-sightedness. A policy designed to please Wall Street speculators and conducted without concern for its effect on emerging economies around the globe.

This policy may ultimately isolate the United States, the dollar and its users from the rest of the globe. And to the long-term detriment of the United States and its citizens as America will no longer have the central role in the global economy.

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