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Late Fed taper may do more harm than good for emerging nations

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Emerging nations heaved a sigh of relief when the Federal Reserve last month decided not to reduce its monetary stimulus.

By postponing the inevitable, the U.S. central bank took pressure off emerging markets to implement reforms that could make them more resilient when the Fed does eventually reverse policy.

"It's very easy to get addicted to high global liquidity," Guillermo Ortiz, chairman of Mexico's largest locally owned bank, Grupo Financiero Banorte, told Reuters.

(Read more: Why the taper may not happen until 2015)

"I think it's better to bite the bullet now to avoid a more painful withdrawal for EM countries in the future," said Ortiz, who has served as both finance minister and central bank chief for Mexico.

Clear examples are the economies of Brazil and India, which have slowed sharply recently due in part to the lack of government action to remove bottlenecks of growth such as high taxes and cumbersome red tape.

Emerging economies cried foul as the U.S. central bank injected trillions of dollars into the financial system, sending a wave of speculative capital into their markets that threatened to drive up inflation and fuel asset bubbles.

Then, in May, Fed chief Ben Bernanke signaled that the central bank might soon begin to scale back the $85 billion in bonds they were buying each month to keep borrowing costs down.

This led to a sharp reversal in capital flows that dragged emerging nations' currencies to multi-year lows and eroded their balance of payments.

The Fed drew fire from some emerging nations for not having prepared financial markets better for a sea-change in its policies.

Economic leaders of emerging nations meeting in Washington over the past few days called on the United States to better communicate its policy intentions to avoid market disruptions.

(Read more: Emerging markets thrive amid US shutdown)

They also applauded U.S. President Barack Obama's nomination of monetary policy dove Janet Yellen to succeed Bernanke at the helm of the Fed in January.

Yellen, who still needs to win the backing of the U.S. Senate, has been an advocate of aggressive action to drive down U.S. unemployment, and would be expected to move cautiously in reining in the central bank's extensive monetary stimulus.

Her nomination, coupled with a protracted political impasse over the U.S. budget and debt ceiling, has already led economists to push back their expectations for when the Fed will begin to taper its asset purchases.

"There is every indication that Yellen has a very sensitive ear to the issues of spillovers, the concerns of emerging markets and understanding of the need of a more consistent way of communication," South Africa's Finance Minister Pravin Gordhan told Reuters on the sidelines of the IMF and World Bank semiannual meetings this weekend.

His Brazilian counterpart, Guido Mantega, told Reuters he favored a gradual withdrawal of the U.S. stimulus.

Be careful what you wish for

Some analysts, however, said emerging markets would do better shoring up their economies than pinning their hopes on the Fed's ability to avoid market disruptions.

(Read more: Why the shutdown could mean no tapering this year)

"When the tapering comes it will be tough for everyone," said James Barrineau, who helps manage $1.89 billion in emerging market debt for Schroders. "We will see additional volatility in the market."

"The assumption that we will have a period of smooth sailing is misguided," he said.

Emerging nations are better prepared to handle higher U.S. borrowing costs than they were in the past, but they still need reforms to strengthen their economies.

A decade of high commodity prices, rising global liquidity and rapid growth that brought dozens of millions of poor into the middle class bolstered the finances and economies of nations from Turkey to Mexico and Brazil.

However, those engines of the global economy have lost steam in the last few years as structural reforms to relax labor laws and bring in long-term investment have lagged.

"I think it's good to have some pressure on emerging-market nations for them to do their own homework," said Alberto Ramos, chief Latin America economist for Goldman Sachs. "It's good that they find endogenous sources of growth rather than just ride the global wave of high liquidity."

(Read More: Emerging markets party as Fed stays put)

Without those reforms many emerging economies could get burned if the Fed ends up dragging its feet for too long and decides to correct course drastically later on.

"When the Fed realizes that they need to taper it would be a bit late and they may need to do it faster," said Ilan Goldfajn, the chief economist of Brazil's largest private-sector bank Itau Unibanco. "When you do it a bit later and faster it could be a real disaster for emerging-market nations."

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