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 ends 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 buildup 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.
The best option then 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 last year. For instance, the South African rand is up 45 percent, the South Korean won 41 percent, the Brazilian real 40 percent, the 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 the Asian Development Bank meeting in Indonesia in May last year. A number of features were identified as necessary for Asia: Social safety nets; help for small and medium-sized enterprises so 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 have 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, as implemented by Chile in 1991 or Thailand in 2006; time requirements stating the minimum time for which inflows must remain, as in Colombia in 2007 or Malaysia in 1997; limits on the size, as in Taiwan last year; a direct tax on financial transactions, as in Brazil last year; 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. However, imposing capital controls sends a signal that could deter future direct investment inflows as well as cause 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.
Gerard Lyons is head of global research and chief economist at Standard Chartered Bank.
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