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QE2 likely to fuel higher inflation in emerging markets, says LGIM


Recent moves by the Federal Reserve to inject another round of quantitative easing stimulus into the US economy has the potential to fuel higher inflation and the potential for asset price bubbles in the emerging markets, according to Brian Coulton, emerging markets strategist at Legal & General Investment Management.

Speaking at LGIM’s Fundamentals briefing, Coulton said the divergence between monetary policy activity in the emerging and developed world is growing.

While official interest rates are heading higher across emerging markets in Asia to combat mounting inflation concerns, western policy makers are doing everything they can to support a weak recovery and ward-off deflation.

Coulton outlined why this divergence in policy objectives has intensified long-standing tensions surrounding trade imbalances and exchange rate policies.

“Asian central banks have been directly intervening in foreign exchange markets, limiting currency appreciation. This has been undermining the relative competitiveness of their trading neighbours in Europe and Japan. As a result of further QE, the US dollar could weaken, further exacerbating this problem”.

Emerging markets have been very resilient to the global financial crisis. Private capital flows to emerging markets as a whole have risen sharply this year as investors seek higher levels of yield and greater potential for capital gain.

“With capital inflows rising, a stance of ‘no change’ in exchange rate policy would also require a stepped up pace of foreign exchange reserve purchases – and therefore increased scrutiny from trading partners,” said Coulton.

As a result, a number of emerging economies – Brazil and Colombia for example – have imposed controls on capital inflows in the form of higher taxes or reserve requirements during the past two years.

Coulton said: “In emerging Asia, tightening efforts are likely to be broader including limiting domestic banks’ short-term foreign borrowing and restricting foreign exchange lending to residents. However, the effectiveness of these tightening measures remains uncertain and higher interest rates and faster currency appreciation through the region seem inevitable as inflationary pressures mount.”

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