By Kevin Gallagher, Associate Professor of International Relations at Boston University. Originally published at Triple Crisis
In 2012, Brazilian President Dilma Roussef scolded U.S. Federal Reserve Chairman Ben Bernanke’s monetary easing policies for creating a “monetary tsunami”: Financial flows to emerging markets that were appreciating currencies, causing asset bubbles, and generally exporting financial instability to the developing world.
Now, as growth increases in the United States and interest rates follow, the tide is turning in emerging markets. Many countries may be facing capital flight and exchange-rate depreciation that could lead to financial instability and weak growth for years to come.
The Brazilian president had a point. Until recently U.S. banks wouldn’t lend in the United States despite the unconventionally low interest rates. There was too little demand in the U.S. economy and emerging market prospects seemed more lucrative.
From 2009 to 2013, countries like Brazil, South Korea, Chile, Colombia, Indonesia, and Taiwan all had wide interest rate differentials with the United States and experienced massive surges of capital flows. The differential between Brazil and the U.S. was more than 10 percentage points for a while—a much better bet than the slow growth in the United States.
According to the latest estimates from the Bank for International Settlements (BIS), emerging markets now hold a staggering $2.6 trillion in international debt securities and $3.1 trillion in cross border loans—the majority in dollars.
Official figures put corporate issuance at close to $700 billion since the crisis, but the BIS reckons that the figure is closer to $1.2 trillion when counting offshore transactions designed to evade regulations.
Now the tide is turning. China’s economy is undergoing a structural transformation that necessitates slower growth and less reliance on primary commodities. Oil prices and the prices of other major commodities are stabilizing or on the decline. It should be no surprise then that many emerging-market growth forecasts are continually being revised downward. Meanwhile, growth and interest rates are picking up in the United States. The dollar gains strength; the value of emerging market currencies fall.
Some analysts predict that emerging-market and developing countries can weather the storm through floating exchange rates, the development of local bond markets, interest rate hikes, or by using some of their foreign exchange reserves. These tools are important, but may not be available or enough.
Floating exchange rates and resulting depreciation can cause the debt burden of firms and fiscal budgets to bloat overnight. Given that most of the capital inflows were in dollars, depreciating currencies mean that nations and firms will need to come up with ever-more local currency to pay debt—but in a lower growth environment.
What is more, most countries didn’t properly invest their commodity windfalls into increasing the competitiveness of their industries. Thus, exports may not pick up at all. An IMF study shows that while Latin America saw one of the biggest commodity windfalls in its history, it has the least to show for it in terms of savings or investment relative to other booms. What is more, the massive exchange rate appreciation that occurred as a result of the tsunami in short-term inflows made many industries uncompetitive and pulled them out of key global commodity chains.
Thus, weak currencies and more debt may be apt to lead to falling confidence rather than surges in exports that will help their countries adjust to the new shocks.
Local bond markets help, but most debt is indeed in dollars and most local debt is held by foreigners who are always the first to dump such debt for foreign shores. Interest rate hikes can also be dangerous. They are often not enough to reverse the flight to the U.S. and can choke off what little growth there is to be had in a downturn. Depleting foreign exchange reserves doesn’t always work, and non-Asian countries whose reserves are a function of the commodity boom will be reluctant to disperse such reserves in the wake of commodity price declines.
The problem is that too many countries failed to regulate during the boom and instead let capital flows storm into their countries to bloat balance sheets and currency values. They are left with increasing debt as currencies slide, and not enough competitiveness to benefit from currency depreciation. The result could be more financial instability that could further threaten prospects for growth and employment.
Emerging-market and developing countries may need to resort to regulating the outflow of capital alongside these other measures. Such moves have traditionally been shunned by international institutions and capital markets alike.
New research on the cutting edge of economics and by the IMF now justifies the regulation of capital outflows to prevent or mitigate a full-blown crisis. The IMF was bold in recommending the regulation of inflows during the surge, but has shied from noting the utility of regulating capital in flight. Worse, new U.S. trade agreements such as the Trans-Pacific Partnership have stripped out balance-of-payment exceptions that would have allowed nations to regulate capital.
If we have learned anything from the global financial crisis it is that nations need as many tools at their disposal to prevent and mitigate financial instability. Instability anywhere can lead to instability everywhere so let’s make sure all tools and hands are on deck.
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From what I recall, during the 1997 financial crisis in Asia, Malaysia
was least affected because of capitol controls. Yet Malaysia was ridiculed
at the time by the IMF, nice to see that their thinking has changed.
Thank You! I was thinking of the exact same thing. But did you notice how they just stopped talking about Malaysia as the crisis bore on everywhere else? Couldn’t have an example that proves their laissez faire/neoliberal theories wrong. Kind of like Iceland today.
When you say capital controls, I believe you mean controls on cap inflows to prevent a borrowing crisis, rather than the other kind of cap controls – stemming currency flight because the country is melting down already.
This article left out the fact that many countries did do things to limit inflows this go around. (back in the 2011-2012 timeframe) It would be interesting to see some analysis if any were successful in managing this never ending cycle. Rather than just waiting for the 2015 Crisis or 2016 Crisis or….and see who is still standing. *
This article is too generic and could be applied to any timeframe and implies it happens to all “emerging” countries equally.
*I’ve been waiting for the meltdown since 2011 – Lets add PIGS, Ukraine, Eastern Europe, and Africa to SE Asia and the BRICs as well. Prolly something wrong with the North and South Poles too! Knowing that all these places are doomed has not been a useful trading tool!!!!!!
http://t.co/itcwBImMpz
aside: could someone pls explain why the russians NEVER opted for capital controls despite $50Bn-$100Bn outflows per YEAR from 2011 on?
Nice call out on global capital flows.
Could this have anything to do with the Fed’s (puzzling) determination to raise rates?
If the Fed raises rates, then what?
Then, presumably, the dollar gains strength and –with the EU and Japan still doing QE–US markets become the logical place to invest one’s money.
Is that too much of a stretch…that the Fed wants to keep markets bubbly by attracting foreign capital just as its purchases of USTs has dropped to zero???
It sounds like a workable strategy for sending stocks higher even while the EMs slump into depression.
Anyone who believes the US FED has any interests other than continuing the all out support of the private banking systems needs to explain how any of their actions at lease since 2008 have made sense for any other reason. The banks have gorged on QE. They have have transferred their toxic waste to the FED balance sheet. Now they need interest rates to rise to make money off new loans. They will also be able to pick up real assets on the cheap now that QE will bankrupt Emerging market countries. The oligarchs are feeling strong. Time for the next phase of the project towards feudalism.
So, you agree that the Fed’s interest rate policy is intended to “bankrupt Emerging market countries”?
in theory….the real trick is for the Fed to create SUSTAINED, REAL GROWTH in the US minus Chinese Labor. Not gonna happen
I’ll be really shocked if the Fed were to raise rates.
They seem to believe their own PR that the economy is getting better. And a lot of investors hate super low rates.
If we have wobbles in the Eurozone, no way. But I could see them tapping on the brakes, say in the late summer or fall, and then losing nerve again. Taper Tantrum 2.0. And recall the first taper tantrum had all sorts of emerging markets central bankers ripshit with the Fed, and the Fed saying they had absolutely nothing to do with the sudden capital exodus from their countries.
The American Conservative has an interesting piece up about merceneries:
http://www.theamericanconservative.com/articles/a-blackwater-world-order/
The thrust of the piece is that the willingness of the Pentagon and others to outsource war and to setup, or allow the formation of, other transnational institutions has changed the role of the state thus weakening it and producing what the subject of the piece calls “neomedevalism” an order in which many overlapping institutions jockey for power and weaken the power of the state to manage things.
While TAC is focused on warmaking I was thinking about this in the context of the capital outflows and horrors like the TPP. One of the central pillars of the state is not just a monopoly on force but a monopoly on money. Once states can no longer control the flow of money then they are stuck riding on their economic instability not reigning it in. In some sense I would argue that TAC has half the story and the discussion here is the other. In many respects what the FED is doing is making economic policy for much of the world and to hell with what the actual governments say.