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Monetary policy: the dam might leak

World economy

MADRID | By J.P. Marín Arrese | Christine Lagarde’s stern warning on potential problems ahead for emerging countries has been delivered in rather a blunt way: “even with the best of efforts the dam might leak”. At the annual Fed gathering in Wyoming she claimed “further lines of defence” were needed to address a financial crisis. The hike in interest rates following the prospect of a progressive tapering in asset purchases by the US, has induced a sharp reversal in fund flows between developed and emerging markets.

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Brazil, India, Indonesia, South Africa and Turkey have witnessed a free fall in their currency values plus large capital outflows destabilising liquidity and credit conditions. The recent decision by the Brazilian authorities to implement a $ 60 billion exchange rate intervention package shows how seriously they are concerned about the current situation. Ms Lagarde has endorsed using capital management measures to address excessive volatility, while emerging countries are calling for a better global coordination and a smoother shift away from cheap money policies in the affluent world. A scarcely disguised criticism on the brisk and somehow clumsy way Mr Bernanke announced the future end of the Fed free ride on liquidity.

The Fed is indeed to blame for delivering an inconclusive and vague message to the markets. Stating that the current $ 85 billion monthly asset buying program would be downsized sometime in the next year, was interpreted by investors as an open invitation to rapidly reshuffle their portfolios. No wonder it has triggered an overshooting in interest rates. The emerging countries have suffered the brunt of such a steep shift but Europe, painfully struggling to anchor its recovery, also stands as a loser.

Criticizing the Fed won’t lead us very far. After all, the US growth and job creation seems largely incompatible with robust monetary stimuli designed to invigorate the economy. Pumping money when the outlook points to indisputable better prospects would only help to fuel future inflation. Thus, a reversal in the easy going conditions was fully predictable.

Most emerging countries have flatly disregarded a hardly sustainable credit boom. Now they fear a sudden halt might lead to turmoil in the financial markets and to the potential threat of a damaging credit crunch. But implementing currency intervention schemes can only work as a short term remedy. Trying to ride on such crutches sooner or later leads to utter collapse. Ensuring full convertibility of their currencies seems the only reasonable way to prevent unwarranted imbalances from building up. Liberalising their economies and opening up their exchange rate to market forces stands as the best bulwark against imported shocks. The IMF should urge them to follow that recipe instead of pleading for a Maginot defence line likely to melt down should the dam leakages turn into a flood.

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