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Could emerging markets pay the price if Abenomics fails?

If Japan's ambitious plan to pull its beleaguered economy out of a deflationary rut falls flat this year, it won't be the only country that feels the pain, economists at asset management firm Schroders have said.

Although the first two arrows of 'Abenomics' have had some success in creating inflation and economic growth, naysayers have cast doubt over whether Prime Minister Shinzo Abe can pull off the third arrow of his plan – structural reform. Thus, they are fearful that the upcoming consumption tax hike in April could damage Japan's economic recovery beyond repair.

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According to Craig Botham, emerging markets economist at asset management firm Schroders, if Abenomics does fail, emerging markets will be left vulnerable.

"We highlighted a number of risks to our baseline forecast [for emerging markets], one of which was a scenario where Abenomics fails," said Botham.

"In the event that yen depreciation does step into overdrive, the most likely impact seems to be on Asian emerging markets' exports to Japan, particularly in the absence of another round of emerging market currency exchange depreciation," he added, referring to the selloff the region suffered in mid-2013 amid concerns the Federal Reserve would taper its asset purchase program.

In the firm's most extreme downside scenario, if the tax hike pushes the economy back into recession, the Bank of Japan will be forced to step up its asset purchase program, further weakening the yen to a level of around 130 to the dollar.

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Shinzo Abe, Japan's prime minister, gestures during a session on the opening day of the World Economic Forum (WEF) in Davos, Switzerland, on Wednesday, Jan. 22, 2014Jason Alden | Bloomberg | Getty Images

At these levels the yen would create two key disadvantages for other countries in the region: a reduction in domestic demand for foreign imports; and it would make Japanese goods more attractive, giving Japanese exporters a competitive advantage.

"Assuming that Japanese companies use the fall in the yen to cut prices (rather than just boost profits through higher export revenues), those who compete with Japanese companies will feel a squeeze on their market share," said Botham.

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Schroders pinpointed South Korea, Taiwan and the Philippines as the most vulnerable to both weaker import demand and Japanese exporters' increased competitiveness.


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