The View | Emerging markets’ dollar flight: the Fed is not to blame, and it knows it

This month, Urjit Patel, India’s central bank governor, waded into the debate surrounding the sharp sell-off in emerging markets by writing a column in the Financial Times, in which he warned that the turmoil could intensify in the coming months due to a sharp reduction in the pool of US dollars heading overseas.

A so-called dollar liquidity squeeze is likely to suck more foreign capital out of developing economies, Patel claims, because of the “double whammy” of a huge increase in America’s budget deficit, following the enactment of President Donald Trump’s trillion-dollar tax cuts, and the unwinding of the Federal Reserve’s US$4.5 trillion balance sheet.

The simultaneous surge in US debt issuance to pay for the tax cuts – which will gobble up a larger share of dollar liquidity – and withdrawal of dollar funding by the Fed poses a far bigger threat to emerging markets, Patel argues, than the pace at which interest rates are raised, the current focus of attention. To avert a full-blown crisis in developing economies stemming from a shortage of dollar funding, India’s central bank governor says the Fed should unwind its balance sheet at a slower pace.