Tuesday 24 Jul 2018 | 01:33 | SYDNEY
Tuesday 24 Jul 2018 | 01:33 | SYDNEY

Emerging markets: QE2 or Titanic?


Mark Thirlwell

14 October 2010 17:12

So, it seems increasingly likely that the Fed will push ahead with a new bout of quantitative easing – or 'QE2', as the markets have nicknamed it. 

With the Bank of England and the Bank of Japan also likely to be pumping out liquidity – and the prospect of the ECB joining in at some point, even if only in belated response to the consequences of standing pat for the euro – there is growing attention on what this might mean not just for the economies directly involved, but also for emerging markets. There's the likelihood of a new wave of capital flows into emerging markets, the possibility of an emerging markets bubble, and the chance of the final destruction of what's become known as Bretton Woods 2.
Of course, the existing differences in growth performance and outlook, interest rates, and market performance between developed and emerging economies have already seen investors busy re-allocating their portfolios towards the latter, especially to countries in East Asia and Latin America. And even back at the start of this year, analysts were debating whether a new asset bubble was appearing in emerging economies. 

Since then, inflows have continued to grow: according to its latest report on capital flows, the Institute for International Finance reckons net private capital flows to emerging markets will rebound to US$825 billion this year, up from US$581 billion last year. While this would still be below the peak of US$1285 billion reached in 2007, it would nevertheless be the second highest result in dollar terms recorded over the past decade. 

Managing these inflows is now a major policy headache, with policymakers in recipient economies facing the choice of allowing their nominal exchange rates to appreciate (but risking exchange rates overshooting and increased volatility as well); of intervening to cap nominal appreciation (but then having to deal with some combination of sterilisation costs and rising domestic liquidity – which seeps into domestic asset prices and inflation); or of adopting controls on inflows and the distortions they entail (Thailand is the latest country to follow this route).

For investors, then, the prospect of QE2 looks like another good reason to expect even more emerging market currency appreciation, or domestic asset appreciation, or a mix of the two: in other words, another good reason to send more money towards emerging markets.

Some of this money will be put to good use. But anyone who can remember the run-up to the 1997-98 financial crises, or indeed the prelude to the Mexican Tequila crisis before that, will be aware of the risks involved in a prolonged period of capital inflows to still relatively under-developed financial markets. Emerging-market policymakers will want to be sure that they can avoid the pitfalls of past experiences of large inflows: in being taken for a ride on the QE2, they don't want to end up like the Titanic.

Photo by Flickr user Amaresh S K, used under a Creative Commons license.