How the emerging world can deal with surging capital inflows
Gerard Lyons
A problem is brewing across much of the emerging world. Many
countries, large and small, are on the receiving end of a surge of
capital inflows and global liquidity. These flows are broad-based,
including bank lending, direct and portfolio investment, plus hot money
which move in response to interest rates.
Most of the money flowing into these markets often end up in equity
or real estate, adding to inflationary pressures in both. Moreover, the
hot money flows can persist until the incentive to speculate is
eliminated.
The longer it is before this is addressed the bigger the problem will
be. Just as excess liquidity contributed to problems in the Western
developed economies ahead of the financial crisis, excess liquidity has
the potential to trigger a fresh financial crisis across the emerging
world.
There is a difference with the West, in that for many emerging
economies this problem is a consequence of success, reflecting optimism
about growth prospects.
Nonetheless it needs to be addressed with an appropriate and timely
policy response. The exact policy may vary for each country.
The best response is greater currency flexibility and a move to
deepen and broaden capital markets, although this will take time.
Thus there will be more immediate responses, including a further
build-up of foreign currency reserves, tightening fiscal policy,
macro-prudential measures to curb rising house prices, and even
short-term capital controls may be needed in some countries if inflows
persist.
All of this creates big policy dilemmas. The question is whether
countries and policymakers will implement necessary corrective action.
The first way to deal with the surge in capital flows is through
currency flexibility. The challenge for policymakers is what has become
known as the 'impossible trinity'; it is not possible to have capital
mobility, exchange rate stability and an independent monetary policy.
Something has to give.
Thus the best option is letting the currency be the shock absorber.
Allowing a currency to appreciate may be like waving a red rag to a
bull: further speculative inflows may be attracted. Despite that, a
number of currencies have appreciated since the bottom of this crisis in
March 2009: for instance the South African rand is up 45 percent, the
Korean Won 41 percent, Brazilian Real 40 percent, Polish Zloty 34
percent or the Indonesian Rupiah 32 percent.
Some countries, keen to suppress appreciation, have intervened,
building up foreign currency reserves. This is ominous, as it was one of
many problems that fed the crisis, but it is understandable.
In
the decade following the 1997 economic crisis, Asian countries saw their
holdings as a proportion of global reserves rise from one-third to
two-thirds. Such intervention was justified partly by the aim to remain
competitive but was aimed at building up safety nets in the event of
another crisis.
This proved to be a positive tool in this crisis, and that lesson has
not been lost on other emerging economies. Thus, intervention may be
seen as desirable for some.
Over the last year, the rise in reserves has been sizeable and has
been largely concentrated in Asia, with reserves rising 39 percent in
Hong Kong, 32 percent in South Korea, 27 percent in Indonesia and 25
percent in China. This has complications, boosting domestic monetary
growth when their economies may not need it, adding to inflation
worries.
Heavy reserve increases can lead to sterilization, as seen in China,
with the need for increased issuance of bills and bonds to soak up the
flows.
Such sterilization does not act as a deterrent to persistent capital
inflows. Instead, it is a further cost to be borne.
Another way to tackle surging capital inflows is through the
deepening and broadening of capital markets. Some of the countries on
the receiving end of inward liquidity have current account surpluses,
explained by high domestic savings.
These countries should bear in mind one of the lessons of last May's
Asian Development Bank meeting in Indonesia.
Then a number of features were identified as necessary for Asia:
social safety nets; help to small and medium-sized enterprises so that
they can be the drivers of sizeable employment growth; and the need to
deepen and broaden Asia's bond markets.
All these issues are commendable, but their implementation will take
time.
Many emerging economies should be tightening monetary policy.
Normally this would take the form of higher interest rates.
The fear is that they would attract more hot money. Given this,
tightening fiscal policy may be an option or the use of macro-prudential
measures.
These are aimed at curbing rising house and property prices, and may
include limits on how much can be borrowed or lent.
The most controversial option can no longer be ruled out: capital
controls. These ideally should be implemented as a last recourse and
only where such measures would be effective. Brazil's use of a tax on
portfolio inflows into equities at the end of last year shows that
controls are back on the policy agenda.
As the scale and speed of inflows has intensified, the question then
is in what circumstances are controls justified and in which situations
are they likely to be effective? Moreover, even if they do work, exits
from controls can be as difficult to manage as their imposition.
There can also be contagion, with controls in one country having
spill-over effects onto others.
There are a series of controls that can be implemented: unremunerated
reserve requirements (URR), as implemented by Chile in 1991 or Thailand
in 2006; time requirements stating the minimum time for which inflows
must remain, as in Columbia, in 2007, or Malaysia, in 1997; limits on
the size, as in Taiwan in 2009; a direct tax on financial transactions,
as in Brazil in 2009; or regulation of trade between residents and
non-residents, as we saw in the Asian crisis in Thailand and Malaysia.
The reality is that controls may not always be the best option.
They may be an effective stop-gap. But imposing capital controls
sends a signal that could deter future direct investment inflows as well
as causing higher premiums to be paid in the future to compensate for
the risk that such controls will reappear.
As capital and liquidity flows into emerging economies, the lesson is
to set policy to suit domestic needs. This was a lesson of the Asian
crisis itself. For some, capital controls may be effective, but, far
better to go for greater currency flexibility and deeper and broader
capital markets.
These measures may not only help cushion or absorb the inflows but
may also help to achieve a balanced global economy.
(Dr. Gerard Lyons is Global Research Head and Chief Economist at
Standard Chartered Bank) |