US financial policy to cause short term problems for emerging economies

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The recovery of the United States is not great news for emerging economies. The tide of investments that increased over the past few years is heading back out.

The news is great for people living in the US and the Euro zone. A much discussed recovery is actually happening. As a result, governments are making changes to financial polices that were meant to help deal with slow economic growth. Some of the policies, such as quantitative easing, were a boon for emerging economies.

Public discussions about the end of quantitative easing were enough to alter billions of dollars worth of investment portfolios. An estimated $64 billion in mutual fund investments was taken out of emerging markets between June and August last year. Much of the rise and fall of the investments can be tied to the policy of quantitative easing carried out by the US Federal Reserve (Fed).

“Five years of unconventional monetary policies in developed countries to address the impact of the global financial crisis led to increased capital flows to developing countries as investors searched for yields as developed countries’ interest rates were kept at historic lows,” explains a new report by the Overseas Development Institute.

“The potential for the unwinding of these unconventional policies caused global instability from May 2013, especially in emerging economies such as India (initially), Indonesia, South Africa, Turkey and Brazil.”

A widespread economic downturn that started in 2008 led global investors to look to countries like Brazil, India and Kenya for high-yield investments. Quantitative easing was carried out by the Fed to stimulate economic growth in the US. It is done by increasing the purchase of treasury and mortgage-backed securities, by the Fed. The result was lower short-term interest rates, a ploy meant to free up spending and investments.

The policy of quantitative easing also made US treasury bonds less valuable to investors. As a result, they considered other ways to increase yields. Risk was what initially kept the investors away from emerging markets, but the low returns on traditional investments and the opportunity to earn more in emerging economies created the right climate for shifting investments.

“As the world’s largest economy, its financial epi-center, and the issuer of the primary reserve currency, actions by the US Federal Reserve will inevitably affect other  countries via trade and exchange rates, capital flows, and overall financial conditions,” explained Arvind Subramanian, a senior fellow with the Center for Global Development, in his testimony to the House Committee on Financial Services Sub-Committee on Monetary Policy and Trade.

The news is not all bad. A healthier global economy means that emerging economies have more places to sell their goods and at better prices, says the World Bank’ Global Economic Prospects report. Foreign direct investment into Sub-Saharan African grew from $37 billion in 2012 to $43 billion in 2013. The money coming in was increasingly for non-extractive sectors, a good sign for the overall economic health of the region, says the report.

Private investments are predicted to drop in Sub Saharan Africa this year, but the World Bank forecasts growth in the years that follow. Private capital in 2016 should exceed that of 2013.

Changes brought by the stabilization of wealthier nations should not have been a surprise to emerging economies.

“Developing countries’ policy-makers should have prepared themselves long ago for this change, and not panic over such a normalization of monetary policy in the rich world,” said Zhenbo Hou of the Overseas Development Institute.

“[S]ince developing countries will be on the receiving end of the negative spillover effects of these policy shifts in the developed world, it is therefore crucial for greater communication and coordination of macroeconomic policies in global fora like the G20.”

Changes are possible and lie within the emerging economies themselves. It is possible that capital inflows to emerging economies could suddenly drop in the coming year. The countries that are unprepared will be left vulnerable,warns the World Bank.

“[E]vidence suggests that countries having seen a substantial expansion of domestic credit over the last five years, deteriorating current account balances, high levels of foreign and short-term debt and over-valued exchange rates could be more at risk in current circumstances,” says the report

Subramanian describes three policy conclusions in his Congressional testimony. The first problem facing emerging economies right now is China. He recommends that countries should resist economic integration with China. Second, the US should provide financial support for the International Monetary Fund so that the body can take on potential problems that emerge. Finally, says that the US, starting with the Trans-Pacific Partnership, can be more transparent with its free-trade negotiations to ensure that they match well with changes at the Fed.

The overall concerns are couched in optimism about the future. A lot will ride on how emerging nations can handle the global economic shifts that will occur in the next year. Those that whether it well will be in a good position to reap the benefits of a thriving global economy.

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Tom Murphy

Tom Murphy is a New Hampshire-based reporter for Humanosphere. Before joining Humanosphere, Tom founded and edited the aid blog A View From the Cave. His work has appeared in Foreign Policy, the Huffington Post, the Guardian, GlobalPost and Christian Science Monitor. He tweets at @viewfromthecave. Contact him at tmurphy[at]humanosphere.org.