SEOUL – Emerging economies are facing significant uncertainty and serious downside risks. One major source of instability is the looming reversal of the US Federal Reserve’s expansionary monetary policy – the prospect of which is generating volatility in global financial markets and threatening to disrupt emerging-economy growth.
The Fed has signaled that its federal funds rate will remain near 0%, at least as long as unemployment exceeds 6.5% and inflation expectations remain well anchored. But when and how the Fed will begin tightening monetary policy remains unclear. What is certain is that, in making its decision, the Fed will not consider its policy’s spillover effects on the rest of the world, leaving affected countries’ policymakers and central bankers to deal with the fallout.
Tighter US monetary policy could intensify the global credit shortage, thereby increasing pressure on Asia’s economic and financial systems. Overreaction and herding behavior by market participants could trigger a sudden reversal of capital inflows, with a severe dollar shortage – as occurred in 1997 and 2008 – straining Asian banks and corporations.
These risks explain why the Fed’s mere suggestion of a potential move toward reducing its purchases of long-term asset (so-called quantitative easing) caused emerging-market currencies and asset prices to plummet this summer. They also underscore Asian economies’ need for stronger financial safety nets.