Wed, Apr 28, 2010 - Page 9 News List

Dealing with the matter of surging capital inflows

The best response is greater currency flexibility and deepening and broadening capital markets to achieve a global balance

By 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 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.

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