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PremiumJahangir Aziz
Mumbai: It’s déjà vu all over again. Emerging market economies are once again flooded with capital inflows, struggling to resist currency appreciation and threatened with asset price surges. And in some emerging market economies, such as Brazil and India, things are further complicated by inflationary pressures. Most major emerging markets, barring India, have responded with large- scale interventions in foreign exchange markets and intensication of capital controls.
That something like this would happen has been on the cards since earlier this year. Emerging markets have led the current recovery, and the growth differential with developed economies is likely to widen. If any of the developed market funds intend to recoup their losses in the crisis, increasing exposure to emerging market assets has to happen. What held them back were concerns of another October 2008 style liquidity and redemption squeeze hitting them. The probability of such a situation arising in the near term has now been significantly lowered: first by the ECBs liquidity support for peripheral European debt, and then, more recently, by the US Federal Reserve announcing a second round of quantitative easing; these assurances opened the flood gates of capital inflows into emerging markets since September.
While the currency appreciation and asset price surge are problematic, the concern that the inflows could reverse may be overblown. Whenever inflows come in such large magnitude, there is bound to be some froth and some speculative flows. Some countries, such as Brazil and Korea, may be under more severe speculative inflows than others, but, by and large, much of these flows are driven by portfolio rebalancing in developed markets rather than currency speculation or just interest rate differentials.
This raises two issues. First, the rebalancing will continue and with that the inflows. Second—and this is the real problem—while the rebalancing exercise from the developed market perspective is a small portfolio shift, it will create tidal waves in emerging economies given their much smaller market size. This situation unfortunately isn’t going to change soon. So as long as the rebalancing goes on, the tidal wave will keep pounding emerging markets.
Tweaking capital controls is not going to slow the pace of inflows as recent experience shows. These flows aren’t seeking short-term interest differential or appreciation gains. They are driven by portfolio rebalancing and unless there are liquidity or redemption pressures in developed markets, these flows will continue. Any substantial quantitative easing by the Fed will only reinforce that redemption pressures are unlikely to re-emerge any time soon, thereby speeding up the rebalancing.
The other policy response, namely large-scale intervention to prevent the currency from appreciating, is far less benign. Capital controls at worst will be ineffective. Interventions on the other hand run the real risk of raising the expectations of future appreciation, thereby inviting speculative flows, adding to the already large rebalancing related flows. And it is this nightmare that emerging markets need to avoid. Letting the exchange rate be the shock absorber, while painful to the real economy, has been an effective way to prevent speculative attacks. Can’t recall the last time a floating currency was targeted by speculators.
Clearly, sudden and large appreciations are disruptive and can potentially harm the real economy. And this has been the argument used to justify large-scale interventions. But the problem is that these countries have not really let the exchange rate appreciate in any material manner when inflows were milder. Consequently, when inflows surge, the size of potential currency adjustment looks scary and is intervened away. In this regard, the Reserve Bank of India’s exchange rate policy over the last 18 months has been very sensible by letting the exchange rate absorb modest capital volatility, setting aside interventions to combat more volatile flows.
But there is a much bigger problem: the dreaded global imbalances. With an ageing population, high fiscal deficit, and thus low savings, developed markets will be short of savings for a long time. And emerging markets will have to run current account surpluses and supply their excess savings to fund the developed markets’ saving shortage. Thus global imbalances are likely to remain. The issue is whether these imbalances remain modest or blow up, threatening another disruptive adjustment in asset and foreign exchange markets. While umpteen combinations of policy options have been suggested in the last five years, ultimately all the potential solutions require growth sacrifice on both sides. Developed markets need to consolidate their fiscal deficits much more quickly, which will reduce demand in their economies and, with that, growth. Emerging markets need to let their exchange rate appreciate more markedly, which will also lower some growth in their economies. These are not new options. The problem lies in coordinating such policy moves. And at the heart of it lies an old problem in economics: the inability to credibly commit to policies that are temporally inconsistent. The exchange rate adjustment is needed upfront, the fiscal consolidation, by its very nature, is a medium-term promise. And someone will need to step up and break this impasse.
Jahangir Aziz is India chief economist at JPMorgan Chase. These are the author’s personal views.
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