NEW YORK – Capital flows to emerging-market economies have been on a boom-bust merry-go-round for decades. In the past year, the world has seen another boom, with a tsunami of capital, portfolio equity, and fixed-income investments surging into emerging-market countries perceived as having strong macroeconomic, policy, and financial fundamentals.
Such inflows are driven in part by short-term cyclical factors (interest-rate differentials and a wall of liquidity chasing higher-yielding assets as zero policy rates and more quantitative easing reduce opportunities in the sluggish advanced economies). But longer-term secular factors also play a role. These include emerging markets’ long-term growth differentials relative to advanced economies; investors’ greater willingness to diversify beyond their home markets; and the expectation of long-term nominal and real appreciation of emerging-market currencies.
Given all this, the most critical policy question in emerging markets today is how to respond to inflows that will inevitably drive up their exchange rates and threaten export-led growth.
The first option is to do nothing and allow the currency to appreciate. This may be the right response if the inflows and upward pressure on the exchange rate are driven by fundamental factors (a current-account surplus, an undervalued currency, a large and persistent growth differential).
But, in many cases, inflows are driven by short-term factors, fads, and irrational exuberance, which can lead to an overvalued currency, the crowding out of non-traditional export sectors or import-competing sectors, a loss of competitiveness, and eventually a large current-account deficit and thus tighter external constraints on growth.
This problem is exacerbated by the fact that the world’s biggest exporter, China, is aggressively intervening to minimize any appreciation of the renminbi. If China doesn’t allow the renminbi to strengthen, other emerging markets will remain wary of letting their currencies appreciate too much and lose competitiveness.
If allowing a currency to appreciate freely is costly, the second option is unsterilized foreign-exchange intervention. This is effective in stemming upward exchange-rate pressure, but it feeds the beast: it exacerbates overheating in already fast-growing emerging markets, causing inflation and leading to excessive credit growth, which can fuel dangerous asset bubbles.
The third option is sterilized intervention. This prevents monetary and credit growth, but, by keeping interest-rate differentials high, sterilized intervention feeds carry-trade inflows, thus contributing to the problem that it was supposed to solve.
The fourth option is to impose capital controls on inflows (or liberalize controls on outflows). Leaving aside the issue of whether or not such controls are “leaky,” evidence suggests that controls on inflows of short-term “hot money” do not affect the overall amount of capital inflows. Thus, such controls are ineffective in reducing short-term cyclical pressure on the currency to appreciate.
The fifth option is to tighten fiscal policy and reduce budget deficits with the aim of lowering the high interest rates that drive the inflows. But sounder fiscal policy might lead to even higher inflows as the country’s external balance and sovereign-risk outlook improve.
A sixth option – especially where a country has carried out partially sterilized intervention to prevent excessive currency appreciation – is to reduce the risk of credit and asset bubbles by imposing prudential supervision of the financial system. This should be aimed at restraining excessive credit growth, which the monetary growth that follows currency intervention would otherwise cause. However, direct controls on credit growth, while necessary, are often leaky and not very binding in practice.
The final option is massive, large-scale, and permanent sterilized intervention – or, equivalently, the use of sovereign wealth funds or other fiscal-stabilization mechanisms – to accumulate the foreign assets needed to compensate for the effects on the currency’s value brought about by long-term inflows. The argument for this option is that long-term secular factors are important drivers of capital inflows, as advanced-economy investors discover that they are underweight in emerging-market assets and reduce their portfolios’ “home bias.”
Sterilized intervention usually doesn’t work: if assets in advanced economies and emerging markets remain perfectly substitutable, inflows will continue as long as interest-rate differentials persist. But the demand for emerging-market assets is neither infinite nor perfectly substitutable for the assets of advanced economies – even for given interest-rate differentials – because these assets have very different liquidity and credit risks.
This means that at some point large-scale, persistent sterilized foreign-exchange intervention – amounting to several percentage points of GDP – would satisfy the additional demand for emerging-market assets and stop the inflows, even if interest-rate differentials remain. As sterilization induces issuance of domestic assets, global investors’ desire for diversification would be met without causing excessive currency appreciation, with all its collateral damage, in emerging markets.
Of course, currency appreciation should not be prevented altogether. When justified by economic fundamentals, the exchange rate should be allowed to rise gradually. But when a currency’s appreciation is triggered by capital inflows that represent the asset-diversification preferences of advanced-economy investors, it can and should be resisted.