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A frequently asked question to which we now have much of the answer is how might the Federal Reserve’s tapering of its bond buying program impact the emerging market economies? A less frequently asked question is how might developments in the emerging markets impact the pace of Fed tapering? This is rather surprising since the emerging market economies now account for around half of global GDP, which means that how they fare has an important bearing on US and global economic growth prospects.

Between May 2013 and September 2013, following Ben Bernanke’s intimation that the Fed might begin tapering its bond purchasing program, capital flows to the emerging markets are estimated by the World Bank to have declined by 30%. This led to substantial exchange rate pressure on a number of large emerging market countries like Brazil, India, Indonesia, South Africa, and Turkey (the so-called Fragile Five). It also led to a significant downgrading of those countries’ economic growth prospects, which prompted the IMF to downgrade its global economic growth forecast by as much as half a percentage point.

In recent weeks, there again appears to have been a substantial reversal in capital flows to the emerging markets in response to the Federal Reserve’s announcement that it will be scaling back its bond purchases from $85 billion a month to $75 billion a month. This reversal is manifesting itself again in substantial pressure on the same key emerging market economies’ currencies as it did following Bernanke’s speech last year. One must expect that this pressure will force these countries to tighten their macro-economic policies in an effort to stabilize their currencies, which is bound to cloud their economic growth prospects in 2014.

Not helping matters in the emerging market countries is their bad electoral cycle in 2014. In all of the Fragile Five countries important elections are to be held in the course of this year. One would think that those elections will both add to investor uncertainty about the emerging markets as well as constrain those countries’ policy response to market pressure on their currencies.

A silver lining for the emerging market is that the pace at which the Fed tapers could be influenced by what occurs in the emerging markets. After all, the emerging market economies will no longer be the principal drivers of global economic growth. In the context of a significant slowing in global economic growth and an appreciation of the US dollar, one would think that the Fed might have added reasons not to taper its bond purchases too abruptly.

The emerging markets might also get some support in 2014 from the Bank of Japan and from the ECB should those central banks move to a more accommodative monetary policy stance. In the case of the Bank of Japan such a response might be expected in response to April’s scheduled VAT tax increases, while in the case of the ECB the threat of European deflation might prompt an easier monetary policy stance. Such moves could at least in part compensate for the negative effects of Fed tapering on the provision of global liquidity in 2014.

Source: The Emerging Markets And Fed Tapering