Emerging markets: Don't panic

http://www.economist.com/blogs/freeexchange/2014/01/emerging-markets-0?fsrc=rss
by R.A. | LONDON

QUICK on the heels of any emerging-market financial wobbles comes public fretting that it is the Asian crisis all over again. As my colleague pointed out yesterday, current financial developments do not really resemble those in 1997-8, for several reasons. Exchange rates are more flexible now. Debt levels are far smaller, relative to reserves, than they were in the 1990s. And the crisis, if it amounts to that, is so far focused on economies that are experiencing acute political difficulties. I think this post from last August still stands up.

But there are probably a few more things that can usefully be said about the current financial situation. The first is that it shouldn't come as a surprise to anyone, and not simply because the rich world has been pursuing "ultra-loose" monetary policy. In fact, Fed tightening cycles have consistently generated capital flow reversals over the past 30 years—the era of financial globalisation. The IMF's World Economic Outlook from spring of 2011 noted:

'Net capital flows to emerging market economies have been strongly correlated with changes in global financing conditions, rising sharply during periods with relatively low global interest rates and low risk aversion (or greater appetite for risk) and falling afterward. Furthermore, economies that have a direct foreign financial exposure to the United States experience an additional decline in their net capital flows in response to U.S. monetary tightening over and above what is experienced by economies that have no such direct U.S. financial exposure. This negative additional effect is larger when the U.S. rate hike is unanticipated and sharper for emerging market economies that are more integrated with global financial and foreign exchange markets, but smaller for economies with greater financial depth and relatively strong growth performance. Finally, the additional response to U.S. monetary tightening is deeper in an environment of low global interest rates and low risk aversion'.

In other words, if one wishes to tap into global capital markets, one must understand the associated risk: that when the world's monetary hegemon changes tack it will dramatically affect the level of capital flows into one's economy. Emerging markets have mostly learned this lesson and developed a strategy that looks reasonably effective at mitigating the worst effects. First, they have discovered it is a bad idea to peg one's interest rate. And second, lightly managing one's exchange rate by intervening in foreign exchange markets to dampen appreciation looks like a good idea; it leans against inflows and yields a pile of foreign exchange reserves that can be deployed to cushion the economy against outflows on the other side of the cycle.

There are downsides to this strategy, however. One is that it can distort domestic investment. A more serious problem may be that it forces central banks to sacrifice some monetary independence; a central bank may be forced to choose between moderating an overheating economy and slowing its currency's rise. On the flipside, emerging-market reserve accumulation also makes it harder for the Fed to maintain adequate demand in America. In other words, emerging markets' chosen strategy for managing the financialisation of the global economy seems to drive a wedge between appropriate monetary policy in economies on both the sending and receiving end of capital flows (though one could argue that removing China from the picture makes things look a bit less difficult).

Is there an alternative to the current emerging-market strategy? Will one might be to dial back global financialisation just a bit. Last year Helene Rey argued that perfect capital mobility may be incompatible with an independent monetary policy. Macroprudential policy, like actions to tighten limits on bank leverage when credit growth accelerates, could deflect some capital inflows while generally safe-guarding the domestic financial system. Some economists worry that macroprudential policies are little more than currency manipulation by another name. Maybe so, but the point seems to be that there is a political demand for policy that allows economies to enjoy the benefits of open capital markets while reducing the risk of destabilising capital flows. The question is whether "macro pru" is a healthier way to do that than outright foreign-exchange market interventions. (On the other hand, research by Michael Klein and Jay Shambaugh suggests that moderate capital-flow limits don't do much to guarantee monetary independence; one has to employ quite substantial capital controls, as China does, to achieve the desired effect.)

What does seem clear is that central banks which unnecessarily sacrifice monetary independence by overreacting to a falling currency are making an unforced error. When exchange rates plunge, central banks are often tempted to lean against the decline by raising interest rates—potentially squeezing the life out of their domestic economies, worsening the domestic financial climate, and doing little to stem outflows. These moves are often justified by the argument that depreciation sends import prices soaring and presages a jump in inflation. Dangerous inflation pressures have been cited by the central banks of Turkey and India, among others, as reasons for recent interest-rate hikes.

Yet research by Joseph Gagnon suggests the inflationary consequences of depreciation are overstated. He examines big currency declines between 1970 and 2004 and finds that in most cases—unless inflation expectations are high and rising—government bond yields typically fall amid a depreciation, and inflation rates are "remarkably stable" after currency crashes.

Central banks should therefore be careful not to make things worse than they need be. Meanwhile, the latest financial-market gyrations would seem like a good time to reinvigorate a discussion on global capital flows that remains woefully incomplete a half decade after the global financial crisis.