COLUMN-Look out for emerging markets inflation-James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

NEW YORK, Nov 5 - Emerging markets could be the first to suffer destabilizing inflation, courtesy of a strong economic rebound, a weak dollar and extremely loose monetary policy in the developed world.

Inflation, in faster growing emerging markets, was not high on the list of worries even months ago, but the speed and strength of the rebound and red-hot asset markets in some places show that it may be a rising threat.

"The surprise could be that inflation in emerging markets really takes off," Amer Bisat of hedge fund Traxis Partners said on Tuesday at a Euromoney foreign exchange conference in New York.

It is not yet a central case, but should price pressures in countries like China, Korea and Brazil take hold, it will leave policy makers in a bind and would roil financial markets.

Interest rate hikes might only attract more hot capital and may be only partially effective. Rising currencies can be self-fulfilling and higher interest rates in emerging markets make carry trades -- borrowing in dollars, for example, and reinvesting in something like Korean won -- all the more attractive.

Other methods of stemming currency appreciation, which stokes inflation, may also become more popular; Brazil in October imposed a 2 percent tax on foreign inflows into equities and fixed-income instruments designed to keep the real from appreciating too quickly.

Emerging market central bankers can expect no help from colleagues in the developed world any time soon. The Federal Reserve will find it economically and politically difficult to hike with unemployment near 10 percent.

"Inflation in emerging markets will be U.S. inflation exported," said Maxime Tessier of Canadian state asset manager Caisse de Depot et Placement du Quebec.

This might actually argue for China to acquiesce to U.S. calls for it to increase the value of the yuan, which will fight inflation at home and would win it friends and influence abroad. It would not be a surprise for China to return to a "crawling peg" under which the yuan is allowed to appreciate upward slowly. That won't happen immediately; a negotiation and wooing period will allow China to extract maximum value from the United States for implementing a policy it may well need anyway.

And of course, with significant spare capacity, the decision will not be easy as inflation in the Chinese economy will not be evenly distributed.

RED HOT

While the data on inflation is still fairly tame, asset markets in many emerging markets are now red hot.

The World Bank this week raised its growth forecast for developing east Asia to 6.7 percent this year from 5.3 percent, but said the strong recovery brought with it new dangers in booming asset prices.

"As liquidity is working its way through the system, and demand is relatively low, the credit is finding its way to stock exchanges and real estate markets. It's a danger," said Vikram Nehru, the World Bank's chief economist for East Asia and the Pacific. The IMF chimed in, citing surging property prices in Hong Kong and "a risk that prices could become driven more by short-term liquidity conditions, divorced from fundamental forces of supply and demand."

Authorities in South Korea have also reacted to a surge in real estate price in and around Seoul, imposing regulations to tighten access to mortgage finance.

Officials have taken some steps to slow the flood of loans they unleashed via Chinese banks this year, but not entirely effectively. Loans by Chinese banks have disproportionately found their way into property and financial speculation, but moves over the summer to limit lending sent the stock market into a tailspin which may have scared off officials. China's four largest banks extended about 136 billion yuan ($20 billion) in yuan-denominated new loans in October, up 23.6 percent from September's 110.4 billion yuan, the China Securities Journal reported on Tuesday.

And it's not just property -- the MSCI Emerging Markets Index is up more than 60 percent this year and currencies in many emerging markets have recorded strong returns.

All of this comes with one very large caveat; if, as is very possible, the recovery in the United States and Europe falters in the new year, then the risk of actual inflation in emerging markets will recede along with their exports to the West. A relapse lower too might bring with it a recovery in the dollar, which would inflict huge pain on speculators who are running dollar carry trades and investing in emerging markets assets and property.

Taking a very long view, strong emerging markets make good sense. Capital should flow to emerging markets. Returns there over the long run will be better, at least if the rule of law prevails. Unless policies can tread a very narrow path, that growth will bring with it inflation and rising volatility.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at james.saft@jamessaft.com and find more columns at http://www.reuters.com/news/globalcoverage/columns