QE could inflate emerging market bubble, OECD warns

Continued monetary easing in advanced economies may create asset bubbles in emerging markets and put upward pressure on their exchange rates, the Organisation for Economic Development and Cooperation (OECD) warns.

Its latest Economic Outlook and Requirements for Economic Policy report was released earlier today. It came just hours before the announcement of the Federal Reserve’s plans for a possible second wave of quantitative easing (QE) and ahead of the G20 Summit in Seoul next week.

Many analysts, including London-based Capital Economics, predict that the Fed will inject another $500 billion (£309 billion) into the economy, but QE in particular has prompted criticism.

The OECD now warns that capital might flow from developed to emerging markets, which can create asset bubbles and put more pressure on exchange rates.

“The recent unilateral interventions in foreign exchange markets and the resulting volatility could prompt  protectionist responses,” the OECD says. Instead, the OECD recommends reaching a common understanding on how global imbalances can be reduced.

“Indeed, exchange rate adjustment cannot do the whole job of rebalancing,” the OECD says.

“Structural reforms, such as the strengthening of social safety nets and the development of financial markets in emerging economies, should be employed to reduce their  savings and dependence on financial markets in advanced economies.” (article continues below)

Structural reforms, as the OECD sees it, could include the liberalisation of product markets and the reduction of high taxes in the labour market. Those could help to recover the output losses associated with the crisis and fix public finances.

As in previous reports, the OECD once again highlights that public deficits have reached “unsustainable levels” as countries are dealing with the aftermath of the crisis.

“Simply stabilising debt relative to GDP in most countries will require a historical consolidation effort of anywhere from 6 to 9% of GDP,” says Angel Gurría, the OECD secretary general. “But in fact even more is needed to bring debt back to sustainable levels.”

Public debt has reached all time highs in many developed countries while the pace of the global recovery has slowed down. Economic output and trade have softened as support from fiscal stimulus is fading.

OECD economies on average are predicted to grow between 2.5% and 3% this year and between 2% and 2.5% next year. Economic activity, however, is likely to differ from country to country.

America’s economic growth, for example, is expected to gain considerable momentum in 2012, while that of Japan is expected to slow down. Within the eurozone, growth rates are likely to vary even more.

In contrast, many emerging markets are still growing at a robust rate. While this is likely to continue, it seems inevitable that the overall rate will slow down in line with the rest of the world.

If global economic growth turns out to be weaker than expected, or deflation persists, central banks could delay the normalisation of interest rates.

The OECD also urges policy makers to generally strengthen the cost-effectiveness of their expenditures across various sectors, including health care, education, innovation and infrastructure development.

Independent fiscal watchdogs, the OECD suggests, could help to ensure that essential consolidation measures are also credible.

“The task of policy makers is to move from crisis mitigation towards rebuilding confidence and stability,” the OECD says. “All the main strands of economic policy – fiscal, structural, financial and monetary – need to contribute in a coherent and consistent manner.”