Quantitative easing (QE) and low interest rates may have staved off depression in the US and Europe but the damaging side-effects are going to be with us for a long time to come. Chief among the victims are emerging markets. At the height of QE , their currencies became rapidly overvalued, as carry traders borrowed in dollars and bought higher-yielding, emerging market bonds. This hit exports and there was talk of a currency war.
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Now, as tapering gets under way, markets are moving in the reverse direction much too rapidly. Brazil, Turkey and India have responded by pushing up interest rates to protect falling currencies. According to The Economist's 'Big Mac index' – a currency comparison tool based on the price of burgers – only the Brazilian real remains overvalued, with the Indian rupee now more than 60% undervalued.
India's central bank governor says that "international monetary co-operation has broken down". He is right. In a globalised world, there needs to be a mechanism for managing the different interests of the US, Europe and leading emerging markets. The failure of US Congress to approve the International Monetary Fund's quota increases for emerging markets shows how far away we are from this message getting through.
Likewise, the G-20 process has gone off the boil now the financial crisis is past the critical stage. But we are rapidly moving into a world where the collective will of key emerging markets is going to count, and where they will be pursuing alternative arrangements if the existing ones fail to deliver. There may even be a trend away from market setting of currency values and free capital flows, as in the China approach.
For years, US law-makers have complained about the weakness of the renminbi and how it creates unfair competition for US firms. On the current road, other leading emerging markets may be tempted to go for a more controlled approach, giving US firms headaches on several fronts not just one. Governments are much worse at setting currency values than markets but the danger is that one giant intervention - QE - may lead to another in currency markets, with a corresponding negative impact on global trade.
