Fifty years from now, when historians look for the defining features of the first decade of the 21st century, they will probably note the rise of worldwide terrorism, deepening internet culture and the devastating global financial crisis. Whether the rise of emerging market economies (EMEs) as a group will rank pari passu with those others will depend not only on what EMEs achieved in the last decade, but also on how they consolidate those gains in this decade and beyond on how governments and central banks of EMEs navigate the post crisis challenges.
Before the financial crisis, “decoupling” was intellectually fashionable. It was held that, even if advanced economies went into a downturn, EMEs would not be affected because of their improved macroeconomic management, robust external reserves and resilient financial sectors. The crisis failed to validate this hypothesis as all EMEs were affected, admittedly to different extents. The crisis reinforced the fact that advanced economies’ and EMEs’ economic prospects are interlinked through trade, finance and confidence channels.
Recent research by the IMF shows that the detrended aggregate output growth of EMEs has strong association with the aggregate output growth of advanced economies, and that this association has increased over time. The coupling is not only strong, but is getting stronger.
If this coupling was the reason EMEs were affected by the crisis, the two immediate post crisis challenges confronting EMEs – surges in capital flows and inflation – trace their origins to the very same coupling. The return of lumpy and volatile capital flows is a consequence of the multi-speed recovery from the crisis. Since capital flows have become such an emotive topic, it is important to be mindful of a few realities.
First, EMEs need capital flows to augment their investible resources, but such flows should meet two criteria: they should be stable and be roughly equal to the economy’s absorptive capacity. Second, capital flows are triggered by both pull and push factors. The pull factors are the promising growth prospects of EMEs, their declining trend rates of inflation, capital account liberalization and improved governance. Among the push factors are the easy monetary policies of advanced economies which create the capital that flows into the EMEs.
To the extent that lumpy and volatile flows are a spillover from policy choices of advanced economies, managing capital flows should not be treated as an exclusive problem of EMEs. How this burden is to be shared raises both intellectual and practical challenges. The intellectual challenge is to build a better understanding of the forces driving capital flows, what type of policy instruments, including capital controls, work and in what situations. The practical challenge is to reach a shared understanding on an organizing framework for cross border spillovers of domestic policies in capital-originating countries, and the gamut of policy responses by capital-receiving countries.
Managing capital flows involves two important things. First, we need to make a judgment on how important the externalities are. And, second, we need to make an objective assessment of what combinations of policies may be used to minimize their impact. Now that it is broadly accepted that there could be circumstances in which controls can be a legitimate component of the policy response to surges in capital flows, policymakers must have the flexibility, and discretion, to adopt macroeconomic, prudential and capital account management policies. Importantly, they should be able to do so without a sense of stigma attached to particular instruments.
The second major post-crisis challenge of emerging economies is inflation triggered variously by the surge in commodity prices, buoyant domestic demand, rapid credit growth and capital flows, all of which raise overheating concerns and associated risks of financial busts. Delay in monetary tightening can raise risks of credit booms and of asset price inflation translating into busts and capital flight. Central banks of EMEs which have begun reversing the crisis driven expansionary stance some time ago, will need to finetune policies taking into account their respective growth-inflation dynamics. This is a tightrope walk: balancing between the goal of restraining demand to keep output at the potential level in the short term and the need to allow space for supply responses so as to raise the potential growth rate in the medium term.
Recent experience suggests that globalization offers incredible opportunities but also poses immense challenges. If the years before the global financial crisis demonstrated the benefits of globalization, the devastating toll of the crisis showed its costs. By far the biggest challenge for central banks of EMEs going forward will be to learn to manage their policy in a globalizing world. They need to be alert to external developments and be able to factor them in to their policy calculus. Central banks of EMEs will need to work harder towards becoming “knowledge institutions”.
Duvvuri Subbarao is Governor of the Reserve Bank of India