For some months now, the US Federal Reserve has held that its easy money stance—near-zero interest rates and expanding the balance sheet by buying government debt—is necessary “for an extended period”. This status quo continued on Wednesday, when the Fed said that US economic conditions are “likely to warrant exceptionally low levels of the federal funds rate for an extended period”.
It’s hard to say from half a world away what US economic conditions warrant. Yet, what the Fed does surely affects more than US economic conditions—a responsibility Washington understood under the Bretton Woods system. But just as US treasury secretary John Connally declared that the dollar is “our currency, but your problem” when that system broke down in 1971, the dollar and the Fed policies behind it may again become a global problem.
Illustration: Jayachandran / Mint
The problem is clear: the rise in liquidity in emerging markets. Major stock indices in Brazil, China and India have risen 26%, 21% and 31%, respectively, in six months, while property prices in Hong Kong—which pegs its currency to the dollar—are shooting up. What’s unclear is what’s behind this liquidity.
One part is the “return of risk”: As the fear that forced investors into the safe US assets disappears, capital flows regain their pre-2007 cyclical nature, further goaded by the expectation that foreign currencies may continue to appreciate.
But one theory about the boom earlier this decade was that capital arguably rode on the back of the easy money policy coordinated among Western central banks. What’s to say this isn’t a replay? Which brings us to the other part: Low rates in the US have created a new beast in global finance, the dollar carry trade. Investors are borrowing cheap dollars to invest in high-yielding assets elsewhere. And high-yielding assets these days are likely to be found in emerging markets.
Consider that Brazil last month went as far as to impose a 2% tax on foreign inflows, to stem appreciation in its currency, which had risen 22% in six months against the dollar.
India is no stranger to such inflows, but it hasn’t used the kind of price-based capital control—called a Tobin tax after Yale economist James Tobin—that Brazil did. Traditionally, India has resorted to quantity controls that limit the amount of investment into, say, government debt. Considering that foreign institutional inflows by September itself had already compensated for the outflows last year, regulators should make sure they possess the tools to meet the challenge.
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