Emerging markets should be in festive mood: capital flows are resuming despite a lukewarm recovery in the US and Europe’s mounting disarray.
However, the surge in capital inflows is raising serious concerns among emerging market policymakers. This is understandable. Emerging markets have undergone a long series of booms and busts due, in part admittedly, to local vulnerabilities – but also to a large extent by external factors.
The importance of external factors was made glaringly clear around the time of the Lehman collapse. Saints and sinners fell under their sway. To illustrate, Chile’s credit crunch was larger than in most other economies in the region, despite it having displayed exemplary fiscal discipline and bank supervision.
The relevance of external factors in emerging market financial crises since the mid-1990s is further corroborated by econometric studies. Although local factors such as dollarization and current account deficits enhance the probability of financial crises, they dwarf in comparison to external systemic shocks.1
Emerging markets are thus facing a critical dilemma: at one end they may opt for allowing capital inflows, which runs the risk of planting the seeds of painful busts; or, at the other end, emerging markets could choose to control those flows, which may keep their economies outside the virtuous circle of growth and development.
As of now, imposing some type of control on capital inflows seems to be having the upper hand. But I am afraid that this policy stance reflects an increase in governments’ risk aversion prompted by the recent crisis rather than by a deeper understanding of the issues at play. This is an unsettling state of affairs that helps to muddle the policy arena.
So can capital inflows give rise to bubbles or bubble look-alikes that are socially costly?
I think so. The reason is simple but not well understood. An increase in capital flows to a given economy has an important side effect: it increases the liquidity of that economy’s assets. In a period in which capital is flowing in, it is much easier to sell one’s assets.
COLLATERAL DAMAGE
Saleability is a salient characteristic of liquidity. The liquidity component makes assets more valuable, increasing their prices. Asset prices are higher than can be accounted for by standard fundamentals. However, liquidity can rapidly evaporate if inflows show a sharp deceleration (a ‘sudden stop’) that impairs assets’ saleability. This could be a result of a flight to quality or higher US interest rates – for example, highly idiosyncratic factors that are not in the hands of local authorities.
Unfortunately, when bubbles burst innocent bystanders outside the financial sector get hurt. Collateral values fall, giving rise to a credit crunch, and a loss of output and employment.
So what to do? First priority should be given to preventing a major impact on the credit channel. Banks are at the centre of the action because of the pre-eminence of bank credit in an emerging market, and banks have a comparative advantage in generating liquid assets (starting with bank deposits, and partly due to the existence of a lender of last resort).
Banks’ liabilities are not all equally stable. A typically unstable item is banks’ liabilities vis-à-vis external investors, like credit lines from external banks. Thus, regulators should put a limit on those liabilities and keep a close eye on off-balance-sheet obligations (South Korea has moved in that direction).
Bank regulation is an imperfect art. Therefore, regulators should also keep track of symptoms that might reflect the existence of an unusual liquidity boom. An example would be a dramatic surge in domestic credit. Recent research shows that periods of high credit growth are leading indicators of future crises.2
Thus, a second line of defence is to slow down credit expansion by increasing reserve requirements. This policy should be supplemented with tight credit market monitoring to make sure that those regulations are not offset by disintermediation.
Finally, controls on capital inflows are likely to generate negative externalities to other economies by pushing undesirable flows to other locations – a fact that unilateral policymaking is not likely to take into account. The IMF could help in this respect by, for instance, issuing a new set of guidelines about controls on capital mobility and warning about the dangers of unilateral action.
Guillermo Calvo is Professor of Economics, International and Public Affairs at Columbia University, New York and a former chief economist of the IDB
1 See, for instance, G. Calvo, A. Izquierdo and L. Mejia “Systemic Sudden Stop: The Relevance of Balance-Sheet Effects and Financial Integration,” National Bureau of Economic Research Working Paper No. 14026
2 For example, A. Schularick and A.M. Taylor “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008,” National Bureau of Economic research, Working Paper No. 15512