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Mix a weak US dollar and low yields in the West with frenetic growth and higher interest rates in emerging markets. Add expectations of rising currencies and a relentless search for yield among global investors. The result is the potent cocktail that has fuelled capital flows to emerging markets this year – but left an economic hangover for policy-makers. The Institute of International Finance (IIF) estimates there will be $708 billion of private capital inflows into emerging economies this year, up from $531 billion in 2009. A shift in global financial power towards the emerging world – as financial markets deepen, economies expand and income levels rise – has turbo-charged foreign portfolio investment in foreign exchange, derivative, equity and fixed-income products.
Policy-makers across the emerging world are now grappling with the macroeconomic fallout: currency appreciation, rising inflation and potential asset bubbles.
Brazilian finance minister Guido Mantega last week lashed out at what he called an “international currency war”, where some countries have sought to weaken their currencies to boost exports and improve trade balances, at the expense of others who have seen their competitiveness plummet as their currencies soar.
The battle to maintain export competitiveness has forced a number of emerging central banks to announce plans to contain currency appreciation through foreign exchange interventions and reserve accumulation.
“We intervene more than other countries because we have a dollarized economy,” Peruvian central bank governor Julio Velarde tells Emerging Markets. “There is the risk of short-term capital flooding the market and rapid peso appreciation.” Peru, Brazil, South Korea, Indonesia and Taiwan have, over the past year, adopted soft capital controls to stem currency appreciation pressures and ward off potentially hot money inflows.
At the heart of the challenge is the economic policy conundrum known as the ‘impossible trinity’. This states that it is impossible for countries to manage their exchange rates, control inflation and allow the free movement of capital all at the same time.
Portfolio flows are heaping on inflationary pressures, and interest rate hikes in the emerging world risk sucking in more capital. How countries balance the demands of exporters and capital-hungry businesses in the coming years will have profound consequences on global capital markets – and unintentional effects on the international monetary architecture.
For many, the issue is ideological.
Before the great crisis, international monetary economists were divided between two lines. Policy-makers across Asia and much of Latin America, dissenting Washington voices such as former World Bank chief economist Joseph Stiglitz, and free trade proponents such as Jagdish Bhagwati, pushed back against what they saw as free capital market dogma in western circles. They argued excessive portfolio inflows led to undesirable appreciation pressures on the exchange rate and, thus, dangerously distorted trade flows.
The Asia and Latin American crises in the 1990s laid bare the risks of foreign debt, and therefore capital controls should be the bedrock of economic policy, they argued. The macroeconomic risk of capital flows, given the nascent stage of economic development in emerging markets, is considerable: if a country has a trade deficit, its currency rate would, other things being equal, depreciate.
This makes goods more competitive internationally, boosts exports and so restores the trade balance. This corrective mechanism is undermined if foreign investment pours into the financial and property sectors. Capital flows fire up consumption, trigger trade deficits and make the balance of payments dependent on capital flows.
Eastern Europe’s credit binge – which created a consumption-led growth model and a bust in 2008 when foreign capital fled – reinforces the dangers of open capital accounts.
Yet in the last decade, proponents of global capital mobility, principally voices in Washington and Wall Street, have argued that financial flows lead to an efficient allocation of resources and cheap capital for borrowers and lenders alike. Lighter financial regulation would boost the private sector and hence economic growth. A stronger exchange rate was a sign of a country getting richer and entering a more mature phase in its development. Liberalization of capital could lead to financial excess, but it’s the unavoidable consequence of free trade and globalization, the argument concluded.
The greatest crisis since the Great Depression has transformed the debate. The US and European financial meltdown reinforced the dangers of financial liberalization and the laissez-faire model.
In February, the IMF shocked global markets with a report that said capital controls are a “legitimate” tool in some cases for governments facing surges in investment.
Earlier this year, Nicolas Eyzaguirre, director of the western hemisphere department at the IMF, told Emerging Markets that the challenge of warding off speculative capital and avoiding boom and bust cycles is, in many respects, “a greater challenge” than the global crisis. “We can see room for capital controls even though they are more blunt in nature,” he said.
The stakes are high. “The world economy will at some point become depressed, and that’s why we should impose controls now to slow down the boom before the bust comes,” says Anton Korinek, assistant professor at the University of Maryland.
For policy-makers, the key calculation is how much foreign portfolio investment is needed for growth – and then determining how any excess tide of capital can be stemmed. Although emerging Asia is a net capital exporter due to its currency regime, private portfolio investment from western banks and institutional investors is needed to meet the region’s infrastructure and corporate investment needs.
In September, India raised the amount foreigners can invest in onshore government and corporate bonds to $10 billion and $20 billion, respectively, to attract more capital for project finance. However, India’s estimated $500 billion in infrastructure investment requirements in the five years ending March 2012 – and a further $1 trillion in the five years after that – underscores the tricky balance between sating India’s capital hunger and managing financial leverage and currency strength.
Zeti Akhtar Aziz, Malaysian central bank governor, tells Emerging Markets: “There needs to be greater policy flexibility and a look beyond the traditional measures of interest rates. When dealing with property or asset bubbles in general, you need to apply a comprehensive approach so there is no over-dependence or over-reliance on any particular measure.”
SOFT CAPITAL CONTROLS
In much of Asia and Latin America this year, policy-makers have enacted soft capital controls to ward off short-term money and financial gearing, aiming to redirect the portfolio flows into more productive investments. Brazil, Peru and South Korea have announced curbs on foreign banks’ currency derivative trades and foreign exchange lending.
In June, Indonesia’s central bank introduced a minimum holding period for its bills, and introduced a wider range of maturities to channel strong capital inflows away from short-term investments. Thailand has eased capital outflow controls this year to ease currency pressures. In May, Russia said by the end of this year it plans to introduce capital controls on fixed-income investments shorter than three years to slow ruble appreciation.
The muted market reaction to South Korea and Indonesia’s controls this year shows that advance warnings and gradual implementation of capital controls need not spook markets. But policy-makers must also outwit financial players: Inflow regulations will only be effective if the measures are costlier than foreign investors’ expected returns.
But a bigger danger looms: restrictions on domestic banks’ borrowings from foreign financial institutions risk undermining medium- to long-term growth, says Aaron Tornell, professor of international economics at the University of California, Los Angeles. “It is politically incorrect to say that portfolio inflows are more important than foreign direct investment – but in many ways it is.”
FDI is typically targeted to natural resources, tradable goods and large corporations with a proven track record. Small and medium enterprises, which are key for long-term private-sector growth, rarely directly benefit from FDI, says Tornell. Instead, portfolio inflows generate more domestic banking liquidity, and thus boost lending to the bank-dependent firms.
What’s more, larger companies have the firepower to circumvent rules by hiring tax advisers and expensive lawyers, says Kristin Forbes, professor of economics at the Massachusetts Institute of Technology.
Tornell at UCLA fears policy-makers may overshoot, and impose capital control policies to generate a smooth credit cycle, but at the cost of reducing long-run growth, which could be more socially costly. “There will inevitably be a trade-off between volatility and growth,” he says.
In any case, while macro-prudential measures and soft capital controls help to stem speculation in the specific markets they target, it’s unclear whether they are effective in reducing total capital inflows and currency appreciation in the long term.
“There is no evidence that controls affect the volume of money coming into the country or that it gives you more monetary independence to control domestic interest rates,” says Forbes. “This is not an ideological position; if capital controls worked, I would be supportive,” says Forbes, who was an economic adviser to US president George W Bush.
A good example of this would be Brazil’s imposition of a 2% tax on foreign investment in equities and debt which, imposed in October 2009, has failed to stem the tide of capital in the country. Nor has it cooled the appreciation of the currency, which has risen 26% against the dollar since January 2009.
AVOIDING THE SWINGS
“There is a limit to how effective capital controls can be, but to say ‘don’t impose any at all’ is like saying you can’t ban murder, because people are going to kill anyway,” says Korinek, who argues that Brazilian capital taxes must rise to discourage foreign portfolio investment. He also advocates a radical approach: imposing unremunerated reserve requirements – which forces foreign portfolio investors to park a portion of their investments in local bank accounts earning no interest and often for more than a year – across all types of portfolio investments in all affected emerging economies.
But the fear of violent “mood swings” in financial markets will reduce the likelihood of strong capital controls, says Rogério Studart, the World Bank’s executive director for Brazil and eight other Latin American countries.
The short-term move to curb foreign capital inflows sits awkwardly with the medium- to long-term desire to internationalize regional currencies, which requires an open capital account. Russia’s prime minister Vladimir Putin has publicly stated that capital controls undermine the spirit of government policy: a fully convertible ruble demonstrates Russia’s global financial strength and provides an alternative to the structurally weak US dollar.
At this stage, most emerging Asian economies cannot afford to take unilateral, extreme measures to the capital account or exchange rate regimes as regional fortunes are intertwined. China’s closed capital account and currency regime has diverted capital flows to regional peers, hiking regional currency appreciation pressures, and thus bringing capital controls to the fore.
“Asian currencies are being used as proxies for the renminbi because the renminbi is not internationalized, and that is problematic in itself,” Korn Chatikavanij, Thailand’s finance minister, tells Emerging Markets. “If the renminbi were internationalized, then our currency problems would become more normalized.”
As a result, policy-makers are embarking on a path of least resistance, unilaterally imposing soft regulations and beefing up financial oversight. However, with capital flows likely to maintain their frenzied pace in the coming years as emerging markets come of age, the policy conundrum is set to be mission impossible.
Against this backdrop, calls are growing for the IMF to flesh out practical guidelines, or a code of practice, on how and when to implement targeted controls depending on the type of portfolio inflows.
But this is not politically feasible. “The IMF has a very important self-interest in not spelling out explicitly what needs to be done – for some in the institution it’s ideological, and for key shareholders, like the US, it’s also self-interested,” says Uri Dadush, former director of the World Bank’s international trade department, citing Wall Street’s influence on the global policy lender.