Capital Controls or Protectionism

GENEVA – Economic growth in emerging markets is more than twice that in “advanced economies” (7.3% versus 3% in 2010, according to estimates by the International Monetary Fund). Not surprisingly, they are attracting capital inflows and featuring higher inflation rates (6.2% versus 1.6%). This is the case in much of Latin America.

In its recent World Economic Outlook, the IMF recommends monetary tightening in emerging markets and continued monetary accommodation in the advanced economies. Alas, both pieces of advice could breed protectionism if not accompanied by effective capital controls.

Most Latin American countries feature strong economic fundamentals, and part of their inflation merely reflects a high weight for food (much higher than in advanced economies) in their calculations of the consumer price index. But this time inflation is not accompanied by exchange-rate depreciation. Quite the contrary. As a consequence, raising nominal interest rates would translate into real interest-rate increases that would widen differentials with advanced economies, thereby attracting even more short-term capital.

While that might be fine for financial investors, it makes little sense to raise interest rates to confront price increases for food (and oil), which already slow the economy by reducing real wages (and cooling off production). But let’s set aside that discussion and assume, for the sake of argument, that interest-rate increases are necessary to address “second-round” effects on price stability. Even so, the advice is dubious.