Defending currencies? More like digging a hole
Emerging market policymakers who have in recent times tightened monetary conditions in an effort to shore up their currencies, may be digging themselves into a hole, economists have warned.
Brazil, Indonesia and most recently India have tightened monetary policy in the face of rapid currency depreciation stemming from worries over the Federal Reserve scaling back its extraordinary monetary stimulus.
But there are concerns that the moves will do little to support currencies with economic growth suffering as a result.
"If you want to keep capital onshore, raising rates is one way to attempt to do that. But under these circumstances of U.S. monetary tightening, I think it's useless," said Uwe Parpart, chief strategist and head of research, Reorient Financial Markets told CNBC.
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"Once the outflows start, policymakers can raise rates all they want, but they are just going to make the economic situation worse and outflows will accelerate. I don't understand the thinking of central bankers, this is a measure of desperation which is not well thought out," he added.
The Brazilian real, Indonesian rupiah and Indian rupee have declined 10 percent, 3 percent and 7.2 percent, respectively, against the U.S. dollar since Fed Chairman Ben Bernanke started talking about tapering on May 22. These currencies have been vulnerable to heavy selling given worries about their large current account deficits.
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Despite aggressive intervention by the Brazilian Central Bank, the real has so far failed to respond to the tightening policies. The central bank has raised its benchmark rate by 125 basis points since April.
"The failure of the Brazilian real to rally in response to monetary policy tightening is disturbing. It is a bad sign for an emerging market currency when the central bank tightens policy and the currency depreciates sharply. It can signal a lack of faith in policy credibility," said Nicholas Ferres, investment director at Eastspring Investments.
A combination of higher interest rates and continued weakness in a currency would present a host of issues for an economy including tighter domestic liquidity conditions, higher costs to service U.S. dollar dominated debt and pricier imports.
Tightening monetary policy in a fragile economic environment also threatens to exacerbate the slowdown in economic growth, say analysts.
Brazil, Indonesia and India together account for 10 percent of global gross domestic product (GDP), thus a slowdown in their economies would have a material impact on global growth.
"This effective tightening of financing conditions across these countries does pose a downside risk to growth, exacerbating sluggish growth in India, Turkey and Brazil, while cooling down relatively strong growth in Indonesia," said Rachel Ziemba, director, global emerging markets at Roubini Global Economics.
Credit Agricole on Monday warned that India's monetary tightening could hit growth in Asia's third largest economy.
"The Reserve Bank of India's actions could lead to a sharp slowdown in growth; unless interbank market liquidity tightness abates soon, we will look to revise our growth and inflation forecasts," the bank wrote in a report.
Last week, the Reserve Bank of India introduced a limit on the amount banks are able to borrow from the central bank at the benchmark interest rate of 7.25 percent. Above that limit, banks would be subject to higher rates of 10.25 percent.
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Several banks have downgraded their growth outlook for India in the last week, with Nomura and Deutsche Bank both lowering their forecasts to 5 percent for the fiscal year 2014, from previous estimates of 5.6 percent and 6 percent, respectively.
—By CNBC's Ansuya Harjani. Follow her on Twitter @Ansuya_H