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The cycle in US monetary policy is now turning decisively towards tightening, a process that could last several years. This will almost certainly lead to more disruption for emerging market currencies and could see the temporary re-imposition of capital controls in some countries.

Turkey has already deployed the classic weapon of choice for a struggling currency – raising interest rates. South Africa and Brazil have done the same.

Raising interest rates in the face of a plunging currency – even if it temporarily stabilises it – is often a cue for speculators to sell it more aggressively. It signals panic. With investor sentiment already turning very sour towards emerging markets more heavy selling can be expected and will become less discriminating.

By Justin Pugsley, Markets Analyst MahiFX.  Follow MahiFX on twitter  @MahiFX

And the unwinding of the US Federal Reserve’s quantitative easing programme has only just begun and it looks fully committed to ending it this year.

Interest rate-hike may only buy temporarily solace for USD/TRY

USDTRY February 2014 technical foreign exchange chart for currency trading

Trying to stop the tide

Like a vast tide QE force fed capital into many emerging market countries – some such as Brazil responded with capital controls to slow the influx to take upward pressure off its currency.

Now the tide is pulling back it is highly likely some of those countries will feel obliged to impose controls, this time to stop capital flight or at least slow the pace of its exit. A plunging currency has negative consequences for inflation and domestic interest rates. In turn that often leads to recession and problems in the banking system.

Countries most likely to impose capital controls are those with large current account deficits and / or with fragile banking systems.

However, the record of capital controls is mixed at best even if the IMF now sees them as potentially beneficial in some circumstances. They helped Malaysia in 1998 and Iceland in 2008 to stabilise their currencies, but in cases such as Venezuela they have helped create high inflation and inequality.

The struggles of emerging market countries and even crises in some of them is fast becoming a theme for 2014. Hopefully, a sustained recovery in the US economy and the avoidance of a financial crisis in China will eventually help stabilise the emerging sphere. Lower currencies will in the short term help their exports and investors will be attracted back in the hunt for bargains.

But these currencies still need to go through a period of readjustment before they find their ‘correct’ levels in the new monetary environment created by the Fed’s taper.

Further reading:  Taper Tantrums or the Start of an Emerging Markets Forex Crisis?