The Fed Versus Emerging Markets

by Tony D'Altorio

The Fed Versus Emerging Markets

by Tony D'Altorio, Investment U Research

Monday, November 8, 2010

So the Federal Reserve has officially launched QE2 in all of its $600 billion glory.

It's pulling that much money out of thin air to purchase longer-term Treasury bonds by the middle of next year.

That makes it a pretty safe bet that Fed Chief Ben Bernanke won't be winning any international popularity contests anytime soon.

His policies may influence Wall Street but he doesn't have much support elsewhere. Emerging markets especially believe QE2 is just a shot at sending U.S. woes overseas.

What does seem certain is that it's creating something similar to the 1997 Asian crisis... though in reverse.

Back then, speculators swamped developing markets with sell orders. That led to Asian nations emptying their central bank reserves to try to keep their exchange rates stable.

Today, we see emerging countries trying to block overseas speculators again. But this time, they want to keep outsiders from buying, not selling their assets and currencies, which have become hot commodities.

Speculators seem especially interested in the anticipated upward revaluation of China's yuan, followed by other Asian currencies.

They're taking steps to protect themselves from that... and that could come back to haunt us. Badly...

Emerging Markets Tightening Grip on Currencies

Emerging markets are hardly standing idly by. They're taking action against the tsunami of U.S. dollars and all of the speculators eager to pounce on outside currencies.

The Financial Times calls this QT2: quantitative tightening two. Emerging markets want to counter the effects of vast capital inflows on their economies.

The dollar keeps falling, prompting speculation in other currencies and inflating them. So to counter that, developing nations are discussing tight restrictions on incoming capital.

Certainly, many Asian and Latin American governments have done just that. That's understandable, considering the side affects of so-called U.S. dollar carry trade, when money moves from a low interest rate environment to a higher one.

That does little to promote capital or employment. Instead, it prices a country's exporters out of foreign markets and can suddenly reverse if speculators pull out, thereby disrupting trade patterns.

HSBC (NYSE: HBC) recently noted that loose monetary policy in the U.S. will lead to capital controls across the developing world as the dollar weakens.

That forces emerging markets to deal with what it calls the "impossible trinity," an inability to allow free flows of capital, while simultaneously maintaining a grip over interest and exchange rates. "The more the West pursues quantitative easing, the more the emerging world, via capital controls, will pursue quantitative tightening."

That especially holds true for China, whose currency looks most attractive to speculators. Knowing that, Chinese officials are discussing tactics to isolate their financial markets from further U.S. dollar inflows.

The simplest way for it to do that is to stop exchanging yuan for dollar payments for non-trade transactions. That would then create a dual exchange rate, with one for trading and the other for financial transactions... just like many countries implemented in the 1930s and 1960s.

The Isolation of the United States Economy

QE2 and all of its international side affects may very well hurt the U.S. in the long run.

It could easily break the world into two competing financial blocs: one centered around the dollar and the other around emerging nations like China, India and Brazil.

China took tentative steps in that direction already last year by supporting Russia's proposal to start using the yuan and the rouble for bilateral trading. China went further last month in supporting Russia' proposal to start trading with the renminbi and the ruble. It has also negotiated similar deals with Brazil and Turkey.

It looks like more and more of the developing countries will begin doing the same too. And all because of the U.S.'s short-sighted policies were designed to please Wall Street speculators and conducted without concern for anybody else.

This may ultimately isolate the U.S., its currency and those who use it. In the end, America will no longer have the central role it enjoys now in the global economy.

Happy Speculating,

Tony D'Altorio

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