The Capital-Flow Conundrum

Emerging economies have been working to protect themselves from the potentially destabilizing impact of advanced-country monetary policy. But, because their strategies also depend largely on monetary tools, they do not address the underlying problems: market, policy, and institutional failures at the national and global levels.

ITHACA – In recent months, emerging economies have experienced capital-flow whiplash. Indications that the US Federal Reserve might “taper” its quantitative easing (QE) drove investors to reduce their exposure to emerging markets, sharply weakening their currencies and causing their equity prices to tumble. Now that the taper has been postponed, capital is flowing back in some cases. But, with little influence, much less control, over what comes next, emerging economies are still struggling to figure out how to protect themselves from the impact of a Fed policy reversal.

When the Fed initially hinted at its intention to taper QE, policymakers in some emerging economies cried foul, but were dismissed by advanced-economy officials as chronic complainers. After all, they initially rejected the very policies that they are now fighting to preserve.

But emerging-market policymakers’ criticisms do not reflect an inconsistent stance; in both cases, the crux of their complaint has been volatility. They have already attempted to erect defenses against the potentially destabilizing effects of advanced-country monetary policy by accumulating foreign-exchange reserves and establishing capital controls. Now they are calling on their central banks to ensure stability by, for example, raising short-term lending rates.

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