Emerging economies at crossroads as US closer to withdraw stimulus

WASHINGTON -- Emerging economies have reached a crossroads and need structural reforms to re-engineer growth and prepare for market turbulence as the US Federal Reserve moves closer to winding down its stimulus policy, leading economists say.

Fed's tapering closer

Emerging markets have attracted large capital inflows in recent years as central banks in the advanced economies adopted extraordinary loose monetary policies that pushed down borrowing costs and inflated the prices of global assets.

However, that flow has begun to reverse in recent months as investors anticipated that the Federal Reserve could start to scale back its bond purchases program, the so-called QE3, after its next meeting scheduled for September 17-18, stoking volatility in currency, bond and equity markets around the globe.

Hung Tran, executive managing director at the Institute of International Finance, told Xinhua that the turmoil in the global financial markets in recent months have many causes, including the Fed's decision to taper QE3, recent upbeat economic data from China, a stabilizing economy in the euro zone, as well as a potential US military strike against Syria that has a contained and short-lived impact on markets.

The biggest move, Tran noted, was "the shift in the regime of liquidity and almost zero policy rates" in major countries amid expectations of the beginning of the end to the extraordinary monetary stimulus.

That means "a period of repricing of assets and rebalancing of portfolios has begun," and "the environment where investors operate has changed," he explained.

The net outflows from emerging market equity and bond funds totaled about $50 billion for the year to date, compared with net inflows of $220 billion in the previous 12 months, according to the IIF.

Tran believed that the US economy has proved resilient and paved way for the Fed to taper its 85-billion-dollar monthly bond purchasing program next week, as "the US household sector is in a very strong financial position to support the recovery in the housing market and consumer spending."

"I think the US economy has recovered and will continue to do well despite the headwinds of fiscal consolidation and eventually tapering by the Fed," he added.

Emerging market crisis unlikely

Although emerging market assets have suffered fierce sell-off in recent weeks, Tran believed that the market turmoil was not likely to develop into a financial crisis like the Asian crisis in 1996-1998.

Firstly, global financial markets have priced in the Fed's first tapering, so that eventually will not have a big impact if it comes.

"Most of market actions to this round have already occurred. If the Fed tapers this month, I do not expect strong actions until next round," he said.

For example, some equity markets have plunged by about 20 percent since May 22, when US Fed Chairman Ben Bernanke signaled to scale back bond purchases later this year for the first time.

Secondly, emerging economies have more flexible exchange rate regime and much more foreign exchange reserves than before, and "we don't see severe economic imbalances in key emerging markets to date," Tran argued.

Thirdly, Christine Lagarde, managing director of the International Monetary Fund, said last month that the international lender was ready to offer financial support if emerging markets needed it during the Fed's exit. The BRICS nations have also agreed to set up a Contingent Reserve Arrangement with an initial size of 100 billion dollars to steady currency markets.

Structural reform needed

However, Tran said it was urgent for emerging economies to address structural problems and reduce economic imbalances to adjust to a new environment of potentially less liquidity and interest rates rising from record lows, as they struggled to stem the swift declines in their currencies and widening current account deficits.

IIF economists Charles Collyns and Saacha Mohammed shared the same view.

"With the pace of reforms lagging in recent years, supply side bottlenecks have emerged, balance sheets have weakened, and productivity growth has slowed in many countries," they wrote in the IIF's latest research note titled "Five Years after the Crisis."

Emerging economies that are better able to push forward effective reforms will be able to "sustain the growth achieved over the past decade and avoid the notorious middle income trap," they argued.

Emerging economies have really reached a crossroads -- how policymakers deal with structural challenges will define their growth prospects and relative attractiveness going forward.

China has realized that it has to advance structural reforms in order to solve the problems hindering its long-term economic development, even though it will mean slower growth, Chinese Premier Li Keqiang said at the opening ceremony of the Summer Davos Forum Wednesday.

"Now the new season for the Chinese economic miracle, one of better quality and higher efficiency, is unveiled," he noted.

"Looking ahead, I see bright prospects for China's development," the premier said.

His view was echoed by the IIF's economists. "China's success in re-engineering its economy to a more balanced growth model is crucial," as it will still be the largest contributor to global economic growth even if its growth rate only reaches the pre-crisis trend of 7 percent, they said in the research note.

The growth story of emerging economies is by no means reaching its end, and the bumpy road and market turbulences now may be just episodes of a new bright season, the economists said.