Nobody is likely to forget anytime soon the bubble that burst in the US mortgage market. It unleashed a massive financial crisis comparable to the Great Depression of the 1930s. It has been more than 2 years and the US and Europe is still reeling from the crippling effects of the crisis. The poor returns in these developed markets have propelled foreign investors to invest in emerging markets in droves on the lure of attractive returns there.
But the over exuberance has raised concerns of a bubble being formed in the emerging markets. Infact, concerns have heightened that that the torrent of money flowing into emerging markets could ignite the next economic crisis. Already billions have been poured into Brazilian bonds, Chinese real estate and Indian equities. What is more, the Institute of International Finance has projected that around US$ 825 bn will be poured into emerging economies this year. That would be up by 30% from 2009.
As a result many of the emerging countries are seeing their currencies appreciate considerably. This has then created a double whammy for these countries. This is because many of them are dependent on exports to fuel growth. As it is, the recession in the US and Europe has substantially dampened demand for goods produced by emerging economies. To make matters worse, an appreciating currency will deal an additional blow to exports. Thus, there are fears of currency tensions arising. Especially if the central banks of emerging nations step in to arrest the steep rise in the value of their respective currencies. This would not then bode well for the US for instance. As it would want the dollar to depreciate to restrict imports, bolster exports and take some pressure of its massive deficit.
Fears have also emanated of the inflows in the emerging nations being of short term in nature. This means that as soon as the developed world recovers, foreign investors would then pull the plug on emerging economies. This would result in a massive outflow with serious consequences. One need look no further than the current global financial crisis to understand the impact of such an event. For instance, after Lehman collapsed, the global crisis escalated very sharply. So much so that FIIs withdrew money in droves from emerging markets including India. This led to stockmarkets in India plunging after the high of 21,000 reached in January 2008.
Many of the emerging markets have been taking steps to control this influx of money. Brazil has doubled its tax on foreign inflows. Countries from South Korea to Colombia have tried to sterilize the impact of flows on their currency by buying up dollars. The Chinese government has come up with various measures to cool off property prices. Stockmarket valuations in India too are beginning to look pricey. Moreover, the rupee has also steadily appreciated. The RBI so far has stayed on the sidelines. But it has indicated its intention of intervening in the currency market, if the need so arises.
And so, central banks in the emerging markets will be kept on their toes for the next many months as they try to gauge the likely impact of such huge inflows on their respective economies.