Who’s Afraid of Tapering?

The Federal Reserve’s exit from quantitative easing has financial markets and policymakers worried, with warnings of capital-flow reversals and collapsing asset prices dominating policy discussions worldwide. But, given that most major economies operate under a flexible exchange-rate regime, such concerns are largely unwarranted.

TOKYO – The US Federal Reserve’s gradual exit from so-called quantitative easing (QE) – open-ended purchases of long-term assets – has financial markets and policymakers worried, with warnings of capital flight from developing economies and collapsing asset prices dominating policy discussions worldwide. But, given that most major economies operate under a flexible exchange-rate regime, these concerns are largely unwarranted.

The logic behind the fear of the Fed’s “tapering” of QE is straightforward. Unconventional monetary policy in the United States – and in other advanced countries, particularly the United Kingdom and Japan – drove down domestic interest rates, while flooding international financial markets with liquidity. In search of higher yields, investors took that liquidity – largely in the form of short-term speculative capital (“hot” money) – to emerging markets, putting upward pressure on their exchange rates and fueling the risk of asset bubbles. Thus, the Fed’s withdrawal from QE would be accompanied by a capital-flow reversal, increasing borrowing costs and hampering GDP growth.

Of course, not all emerging markets, according to this logic, are equally exposed. Among the most vulnerable countries are Turkey, South Africa, Brazil, India, and Indonesia – the so-called “Fragile Five” – all of which are characterized by twin fiscal and current-account deficits, high inflation, in addition to faltering GDP growth.

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