In late January, Raghuram Rajan, Governor of the Reserve Bank India (RBI), lamented that international monetary cooperation has broken down, noting that “industrial countries have to play a part in restoring that, and they can’t at this point wash their hands off and say, ‘We’ll do what we need to and you do the adjustment’.” 
In advanced economies, Rajan’s remarks were greeted with sceptical criticism.  That was a self-interested mistake. After all, the recent market volatility has not been limited to only emerging markets. It started with bad data from the U.S. and the UK, and weak seasonal data from China.
Of course, many emerging economies have substantial challenges of their own, including budget and trade deficits, relatively high inflation, excessive reliance on commodity-led growth, and political divisions, besides long-standing issues of governance and corruption.
However, these challenges did not come out of the blue only in June and December 2013, or January 2014 – which is when the U.S. Federal Reserve first flirted with and then initiated tapering that caused a reverse “hot money” tsunami in emerging markets.
The dual mandate of the Fed, which is focused mainly on the U.S., requires it to maintain full employment and to keep prices in check. It originates from an Act of 1977 and precedes three decades of global economic integration.
If Ben Bernanke made possible America’s massive monetary stimulus, it is the job of his successor, Janet Yellen, to complete the Fed’s tapering and eventually to hike up the policy rate. She chose as her second-in-command Stanley Fischer, a highly-regarded central banker, who had a major role in the bailouts for Mexico and Brazil in the 1990s during his stint at the International Monetary Fund.
Internationally, Yellen’s nomination at the Fed completes the transformation of the central bankers in major advanced economies. At the European Central Bank, Mario Draghi has replaced Jean-Claude Trichet, while Mark Carney has taken over the Bank of England. In turn, Haruhiko Kuroda has taken the Bank of Japan aggressively toward looser monetary policy. The old laissez-faire club is gone. The neo-Keynesian club is in. But despite different monetary approaches, the national perspective remains much the same in each, including the U.S. Fed, which moves markets worldwide.
In 2008, it was only the joint action of the G20 nations that deterred a potential global depression. However, as the immediate threat subsided, cooperation between the advanced and emerging economies began to linger.
Before the global financial crisis, the Fed’s policy rate exceeded 5%. By December 2008, Bernanke had cut the rate down to 0.0-0.25%, where it remains. As the recession exhausted the traditional rate cuts, central banks opted for non-traditional instruments, including several rounds of quantitative easing (QE). With investors seeking higher returns, these measures drove “hot money” (short-term portfolio flows) into high-yield emerging-market economies, which, in turn, caused asset bubbles and inflation in Asia, Latin America, and elsewhere.
As a result, the emerging markets – including the People’s Bank of China (PBOC) and India’s RBI – moved in the opposite direction, hiking rates. As Chen Deming, China’s then-Minister of Commerce, complained, “China is being attacked by imported inflation.”  In Brazil, interest rates soared to close to 11%. South Africa’s finance minister Pravin Gordhan said that the Fed was undermining the G-20 leaders’ “spirit of multilateral cooperation.” 
In the advanced economies, the new monetary instruments came with a trade-off: today, the Fed’s swollen balance sheet exceeds $4 trillion. Yellen has defended the bond purchases.
Meanwhile, in the emerging economies, we have seen the reversal of some of these “hot money” flows.
Until the Xi Jinping-Li Keqiang era, China tackled economic challenges with stimulus, leverage and deferred reforms. That is no longer an option. The message was brought home in the aftermath of Bernanke’s suggestion of possible Fed tapering in June 2013, when China’s inter-bank rates soared, but the POBC did not intervene. In the past, the authorities had resorted to new injections of liquidity. Now it was declined.
A déjà vu ensued in December. Initially, observers called the outcome a “cash crunch.” In reality, the PBOC and China’s new leadership chose not to intervene – to deter unsustainable liquidity creation and the rising probability of a debt default.
From Brazil’s standpoint, the timing of the Fed’s tapering has been very challenging. After all, the emerging market turmoil sparked the depreciation of the real, thus giving Brazil’s Central Bank (BCB) an opportunity to opt for a more hawkish approach. Further, stagnant domestic conditions in the short-term have enabled BCB to prolong its rate-hiking.
Following the Fed’s tapering, the eclipse of excessive liquidity flows and the sharp depreciation of currencies in the emerging markets, some central banks have been intervening in the foreign exchange market to curb depreciation pressures on their currencies. Instead of selling international reserves, they have offered U.S. dollars via foreign-exchange swaps.
In Brazil, these interventions have been fairly typical in the past few years. Hoping to prevent sharp movements of the U.S. dollar via Brazil’s real, the BCB has sold U.S. dollars via currency swaps or bought dollars via reverse currency swaps. With the Fed’s tapering, these interventions seem to have spread among emerging markets.
Last August, India’s RBI opted for dollar/rupee foreign exchange swaps with oil companies, hoping to shore up the rupee, which seemed to calm the markets. Rajan has restored the credibility of India’s monetary policy, but other internal sources of risk remain, including the 2014 election and the pace of fiscal consolidation.
Indonesia offers another example. In the last quarter of 2013, the country’s current account deficit improved significantly and is likely to recover further as long as exports continue to grow. However, inflation has accelerated more than expected and above Bank Indonesia’s (BI) target. While BI may not cut rates further this year, it is likely to turn to liquidity management tools – more deposit rate hikes, repos, or other open market operations – to contain credit growth and import demand.
How will Yellen enforce the Fed’s dual mandate? In the near future, she will continue to trim bond purchases pragmatically. The focus will be first on U.S. jobs. Yellen has suggested that monetary policy should keep inflation to 2% and achieve an unemployment rate of 6%. In turn, the Fed may hold rates close to zero until early 2016 and may keep them lower than traditionally recommended until 2018.
Meanwhile, the central banks in some emerging markets may continue to resort to liquidity management to make their reserves go further. Yet, their ultimate success depends on whether the sought-after intervention actually works. Countries resorting to measures that simply delay potential adjustment run the risk of a significant hit on fiscal balances, if they are eventually forced to let the currencies depreciate. In this case, instead of reaping the rewards of depreciation, these countries must cope with the effects of lower credit quality.
At best, such liquidity management can buy time in the short-term to focus the nation on its fundamental challenges. At worst, it can serve as a moral hazard, which will defer depreciation, while causing losses from the swaps and, eventually, sovereign ratings downgrades.
Paradoxically, during the 2008/9 global crisis, when America was the epicentre of the global financial crisis, the value of the dollar went through the roof. In the past half a decade, things may have got even more ironic. Instead of efforts to enhance multilateral G20 cooperation, the Fed’s moves are now leading major central banks to sustain unilateralism – not by the fundamental power of the U.S. economy, as was the case in the post-war era, but by confidence in fundamentals that no longer prevail.
Thanks to their experience and global reach, Yellen and Fischer will certainly try to anticipate the international implications of their policy. But such considerations remain secondary to the unilateral monetary policy. After all, neither Yellen nor her opposition in America question the exclusive focus on the U.S.–defined jobs, inflation, quantitative easing, forward guidance and asset bubbles.
And that, precisely, is the real dilemma. In a nascent multi-polar world, it is impossible any longer to conduct unilateral monetary policy without substantial “collateral damage.”
Dan Steinbock is based in New York City. He is the Research Director of International Business at the India, China and America Institute, U.S., a visiting fellow at the Shanghai Institutes for International Studies in China and at the EU Centre, Singapore.
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