Coordinating global monetary policy

THAT the central bank of the prime economy of the world is powerful is not in doubt. But whether it should be responsible for the fate of the rest of the world is. Earlier this month, the US Federal Reserve came under fire from Reserve Bank of India governor Raghuram Rajan, who said that the Fed should think about how its policies are affecting the rest of the world. His comments were echoed by the International Monetary Fund, which called on central banks to ensure that an international funding crunch does not happen.

The flak the Fed is receiving is due to its decision to taper its purchases of long-dated bonds. This has hit financial markets and emerging market assets in particular. Since last May, when the first hints of tapering started to take shape, money has flowed out of regional assets, which have become less attractive upon higher anticipated yields on US long-dated bonds. The Indonesian rupiah, the Malaysian ringgit and the Indian rupee all plummeted against the US dollar last August. In late January, fears of slow Chinese economic growth and financial stability concerns were compounded with political instability in Turkey and the devaluation of the Argentinian peso. As the lira fell by more than 10 per cent against the US dollar in a matter of weeks, Turkey's central bank dramatically doubled interest rates overnight. India, too, has surprised consensus by raising rates for the third time in five months. South Africa raised rates too. The S&P 500 was not spared, falling from 1,850 points in mid-January to about 1,740 in early February, before recovering in the past week.

Emerging market central banks are caught in a dilemma. When rates were low, hot capital inflows caused asset bubbles in sectors like infrastructure and real estate. Now that rates might rise, capital outflows are causing their currencies to come under pressure. If local exchange rates are allowed to slide against the dollar, the cost of imports will increase and undesired inflation is the result. Companies might find it difficult to repay debt denominated in dollars. Foreign investors will also be reluctant to come in. Instead of a cheaper currency attracting investors, fear tends to feed on itself, resulting in further declines. Meanwhile, if interest rates are hiked to cool inflation, domestic growth might become a casualty. Capital controls can be put in place to prevent outflows or inflows, but they come with costs of their own.