Analysis: Emerging market crunch may cause Fed to think twice

By Mike Dolan

LONDON (Reuters) - If currency turbulence in emerging markets escalates into full-scale investor flight, the Federal Reserve may have a fresh headache in deciding when to slow its dollar printing policy.

Given all the obvious influences on Fed policy - domestic inflation, jobless youths, long-term unemployment, stuttering credit creation or banking stability - gyrations on markets from Turkey to South Africa or South Korea may seem tangential.

But an enmeshing of the United States and the economies of the developing world since the turn of the century means the link between U.S. monetary policy and currency runs on the other side of the world could be tighter than many assume.

Another financial shock now in emerging economies that use vast holdings of U.S. Treasury bonds as capital insurance buffers could complicate a Fed exit from quantitative easing.
"As with so many previous emerging crises, although the Fed often triggers the withdrawal, it's then forced to turn more accommodative by default as a result of the fallout," said Simon Derrick, strategist at Bank of New York Mellon.
"MA(f)D"
To avert the sort of protracted and devastating investment freeze they suffered in the late 1990s, economies across Asia and around the globe have built up huge hard-cash buffers as protection against future 'sudden stops' in foreign financing.
Over the past decade, emerging economies have absorbed trillions of dollars of western investment seeking higher growth and yields, while China's historic emergence into the world economy has helped fuel a commodities "supercycle".
In buying up the incoming dollars, euros and other hard currency to prevent a rapid appreciation of their own local currencies, emerging central banks have amassed some $7.2 trillion in reserves. That mirrors the estimated $8 trillion of private capital flows to emerging markets since 2004.

The International Monetary Fund estimates more than 60 percent of that total is held in greenbacks, putting dollar holdings at about $4.4 trillion. At least 80 percent of that - some $3.5 trillion - is banked in top-rated U.S. bonds, mostly Treasuries, IMF surveys suggest.

On those broad calculations, China alone holds about $1.6 trillion of U.S. bonds, while the rest is spread far and wide across Asia to Russia, the Middle East and Latin America.

This seemingly stable set-up was dubbed "Bretton Woods II" by Deutsche Bank economists 10 years ago, while former U.S. Treasury chief Larry Summers dubbed it "mutually assured financial destruction" a few years later.

But aside from a relatively brief stress-related financial heart attack that boosted the U.S. dollar briefly in 2008/09, these buffers have not really been tested.

If the sudden and steep emerging currency sell-off against the dollar - which on Fed indices has reversed their surge early this year in just three weeks - were to snowball, there is every chance these reserves will need to be sold to stabilize markets.

Any rundown of currency reserves may also require the sale of Treasuries, potentially steepening the rise in long-term U.S. interest rates, boosting the dollar and compounding the shock.

Could the Fed tolerate that? Back in the 1990s, then-Fed chief Alan Greenspan reversed a 1997 interest rate rise that some blamed for pushing emerging markets over the edge, cutting three times in 1998 as the crisis deepened - even though there was little material impact on the U.S. economy and the Wall St stock bubble continued inflating.

Might his successor Ben Bernanke do likewise - or at least act to tamp down talk of slowing QE for fear of a growth-sapping surge in U.S. Treasury yields?
There are several question marks over this sketch of events. Emerging economies may not be as fast to run down reserves without the fixed currency pegs of the 1990s, instead allowing more flexible exchange rate regimes to take the heat and enjoying a competitive boost from better terms of trade.
Outgoing Russian central bank chief Sergei Ignatyev said only last week: "The key is that our exchange rate is almost floating and close to free float."
That said, Russia, like Poland, was forced to run down between a fifth and a third of its entire reserves during the worst of the credit crisis in 2008/09.

Others reckon the very existence of hefty reserve buffers in many emerging countries will be sufficient to forestall capital flight. Deutsche Bank's Markus Jaeger points out that China, Korea and Russia run small current account surpluses and have short-term debts of less than 50 percent of reserves.

What's more, the Fed may feel the U.S. economy is strong enough to absorb some hit from sharply higher yields and push ahead regardless.

But emerging market crises are notorious for taking on a life of their own - mostly due to investor fear of illiquidity and the ability to sell securities at fair prices. That forces many to pre-emptively protect themselves by exiting early.

If that happens, the potential panic will likely require some response at home - or eventually in Washington.

(Editing by Catherine Evans)