Beggaring the World Economy

CHICAGO – Global capital is on the move. As ultra-low interest rates in industrial countries send capital around the world searching for higher yields, a number of emerging-market central banks are intervening heavily, buying the foreign-capital inflows and re-exporting them in order to keep their currencies from appreciating. Others have been imposing capital controls of one stripe or another. In recent weeks, Japan became the first large industrial economy to intervene directly in currency markets.

Why does no one want capital inflows? Which intervention policies are legitimate, and which are not? And where will all this intervention end if it continues unabated?

The portion of capital inflows that is not re-exported represents net capital inflows. This finances domestic spending on foreign goods. So, one reason countries do not like capital inflows is that it means more domestic demand “leaks” outside. Indeed, because capital inflows often cause the domestic exchange rate to appreciate, they encourage further spending on foreign goods as domestic producers become uncompetitive.

Another reason that countries do not like foreign capital inflows is that some of it might be “hot” (or dumb) money, eager to come in when foreign interest rates are low and local asset prices are rising, and quick to leave at the first sign of trouble or when opportunities back home beckon. Volatile capital flows induce volatility in the recipient economy, making booms and busts more pronounced than they would otherwise be.