Many emerging market (EM) policymakers will be quite happy that investors appear to have lost some of their enthusiasm for emerging markets in recent weeks. Since one of their big worries in recent months has been the risk of ‘excessive’ capital inflows, policymakers should be rejoicing that some of the recent flows data show a preference for developed market (DM) exposure vs EM exposure. The bigger threat to EM's is the Rise In Interest Rates in Europe and the USA.
A rise in US rates could be a more serious kind of threat, and we think the best way to look at this is by understanding that an emerging economy’s vulnerability to this risk lies in a combination of a) how big each country’s external financing requirement is, and b) how easily a country’s capital inflows can go into reverse. We try to capture this vulnerability for EM, and find that the countries most likely to suffer include Turkey, Brazil, South Africa, Indonesia, Poland, Egypt and India: a list that is similar to the list of countries worst affected by the prospect of rising US rates in 2004.
Where does the risk of capital outflows come from? We look at three main risks: i) inflation in EM; ii) a fall in the GDP growth differential between EM and DM; and iii) the possibility of a sooner-than-expected rise in US interest rates.
The first two risks, in our view, are probably not big enough to undermine our view that EM currencies are likely to appreciate in 2011. In fact, the opposite may be true: growing inflationary risks may actually facilitate a broad exchange rate appreciation in EM, especially if China allows the RMB to strengthen.
In general, though, levels of external vulnerability in EM overall are quite modest. So, we think the threat of an early US rate hike — which we do not, in any case, forecast — won’t seriously undermine confidence in EM.
So, we expect countries to continue to pursue tighter monetary policy, with the result that exchange rates strengthen. And even if more countries experiment with ‘quantitative tightening’ through the use of macro-prudential measures, we don’t think this is incompatible with strong capital flows and strengthening currencies, unless those macro-prudential measures are seen to increase country risk (which may be the case with Turkey, but not Brazil).
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