LONDON, Sept 13 U.S. money printing has ignited currency wars in the past but a third round of Fed stimulus could prove less inflammatory as weakening economies dampen investors' enthusiasm for emerging markets.
The U.S. Federal Reserve appears set to launch additional bond-buying at its Thursday meeting, or at least signal the timing of the operation, known as quantitative easing, or QE.
The unconventional stimulus however is widely perceived by emerging policymakers as an attempt to devalue the dollar against their currencies - a currency war, as Brazil has dubbed it.
Past QE bouts have indeed triggered almost Pavlovian reactions among investors to sell down the dollar and buy higher-yielding, higher-risk currencies, assets and commodities.
The unprecedented inflows of yield-hunting cash pushed emerging currency values up about 7 percent in the half year following QE1, Thomson Reuters data shows, while local currency debt gained 15 percent. More QE in 2009 and 2010 added to gains, pushing some currencies to record highs.
Some fear more of the same in 2012.
Chile's finance minister Felipe Larrain said this week that QE3 was a matter of concern for countries with floating currencies. Even before the announcement, the Chilean peso has surged to 4-1/2 month highs against the dollar.
Larrain may be right to worry. The peso is supported by a high 5 percent interest rate and the central bank has been reluctant to lower it because domestic growth is robust.
But the picture elsewhere is different. Quite simply, emerging currencies are no longer an outright buy as their economies slow and yield premia are eroded.
Kieran Curtis, who runs an emerging debt fund at Aviva, notes that the majority of emerging currencies, including China's yuan, have lost ground versus the dollar this year as economic growth has slowed and central banks from Brazil to South Korea have cut interest rates.
So not only is the interest rate differential between U.S. and emerging interest rates smaller than in the past, inflation-adjusted interest rates are actually negative in many developing countries.
"The immediate gut reaction will be for currencies to strengthen but we'll probably see less of the QE spilling to emerging markets than last time," Curtis said.
"Investors are slightly less comfortable with emerging currencies now than they were."
Indeed, a dollar-based investor would not have made much money on emerging domestic bonds this year if not for falling yields, caused by rate cuts. That's the reason 80 percent of investment flows to emerging debt in 2012 have gone to dollar bonds.
As exports falter, Asia's once-mighty current account surplus has dwindled, Brazil has swung into a deficit and balance of payments gaps in countries such as India, South Africa and Turkey are not far off record highs.
"(In 2010) expectations of growth in Asia were very high; now overall, globally it is a slowdown, in South East Asia and China in particular," Thailand's central bank governor Prasarn Trairatvorakul told Reuters this week.
Domestic demand in most countries is not robust enough at this point to offset an export collapse, and that points to more interest rate cuts ahead, analysts say.
Emerging currencies have firmed in recent weeks on the Fed QE hopes as well as the improving euro zone picture. QE3 would be "a helpful but insufficient condition" for this rally to be extended, say UBS analysts.
"The health of the global business cycle is a far more important driver for emerging currencies than the size of the Fed's balance sheet," UBS told clients, adding it was not positioned aggressively for emerging FX strength versus the dollar.
Second, the assumption of more Fed bond buying seems to be priced into most asset prices. And many reckon QE may have lost its power as markets interpret the continued recourse to money-printing as a sign of desperation.
"The first QE wave was different from what we had ever seen before from the Fed or any Western central bank," said Philip Poole head of global and macro strategy at HSBC Global Asset Management. "But each successive wave is less powerful ... there is a law of diminishing returns."
Poole notes that emerging central banks are prepared this time for QE's side effects and will not hesitate to counter with direct dollar buying, rate cuts or even capital controls which now have the blessing of the International Monetary Fund.
Brazil, for instance, has already been acting. It intervened this week to push down the real which had firmed to three-week highs on Fed expectations.