New Rules for Hot Money

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).