Week In FX Asia - IMF's Lagarde: 'Transitions On An Epic Scale'

Includes: EWJ, FXA, FXI, INR, UDN, UUP
by: Dean Popplewell

Asian risk rallies have run out of steam, ending this week with most Asian equity indexes and currencies trading down. Is the global economy -- and especially emerging markets -- play out the IMF's Lagarde's somewhat dire prediction? Supposedly, the global economy is experiencing "transitions on an epic scale" and she warns that current turbulence in emerging markets could knock between 0.5% and 1% points off their growth. Most of this is based on this summer's market reaction to "taper talk," and more importantly their vulnerability to future changes in the pattern of global capital flows.

Ever since Bernanke entertained the possibility of tightening the liquidity tap by paring back on the Fed's $85 billion per month bond-purchasing program, the markets have witnessed a massive outflow of capital at record speed; India has been one of the hardest hit from capital flight. Lagarde has indicated that the global economy's "immediate priority is to ride out the turbulence as smoothly as possible," and that "currencies should be allowed to depreciate. Liquidity provision can help deal with dysfunctional market behavior. Looser monetary policy can also help."

If capital flows to emerging markets continue to become scarcer, the market will be relying on signs that their economies can export their way out of any problems. EM export growth will need to rely on a number of factors: very cheap real exchange rates, plentiful credit availability in developed markets, and strong Chinese growth. A danger to their markets is closer at hand -- Japan. Prime Minister Abe's recovery plan hinges on a cheap yen, and export substitution may be of concern.

The Bank of Japan earlier this morning maintained its policy stance and its view that the Japanese economy is recovering moderately. A weaker currency has currently been put on hold due to the partial U.S. government shutdown. Abe and the rest of the world requires a quicker resolution to the U.S. budget impasse and ceiling debt. Otherwise, we will all be in that one boat with the leak.