Emerging economies and capital flows – the poisoned chalice

It may take another international financial crisis for a more balanced approach at the IMF towards liberal capital flows and capital-flows management.

“If there is little way for countries across the globe to avoid the spillover effects of unconventional policies emanating from the large central banks, should the large central banks internalise these spillovers? How? And will it be politically feasible?”
Raghuram Rajan at the first Andrew Crockett Memorial Lecture (June 2013)


Emerging economies get the middle finger

On 11 February 2014, in her first public appearance as the Federal Reserve chairperson, Ms. Janet Yellen is said to have reiterated the oft-repeated view in recent weeks that the Federal Reserve shall not be swayed by the happenings in the developing world:

This is how the Financial Times reported on this particular aspect on 12 February: “In her first appearance before Congress as Federal Reserve chairwoman, Ms Yellen noted emerging market turmoil for the first time, saying that the Fed was “watching closely the recent volatility”. However, she showed no sympathy for complaints that the Fed has failed to co-ordinate its policy with other countries…“Our sense is that at this stage these developments do not pose a substantial risk to the US economic outlook,” said Ms Yellen. “We will, of course, continue to monitor the situation.”

Of course, more than the testimony, commentators have pointed to paragraphs in the report that the Federal Reserve presented to the Congress in which they pointed to vulnerabilities in emerging economies as the source of the problems that their currencies and assets have faced in financial markets.

Someone needs to remind the new Fed Chairperson of this:

We will conduct all our economic policies cooperatively and responsibly with regard to the impact on other countries and will refrain from competitive devaluation of our currencies and promote a stable and well-functioning international monetary system. We will support, now and in the future, to candid, even-handed, and independent IMF surveillance of our economies and financial sectors, of the impact of our policies on others, and of risks facing the global economy.”

Further, the refrain to rebalance demand between developed and developing world has been constant in all G20 summit meetings in 2009 and in 2010. That is what the developing world has done – not in the most ideal fashion but they have run current account deficits. Have developed countries rebuilt their savings rates? Household saving rates have barely budged in the US and in the UK. So, why should emerging economies be punished for keeping up their end of the bargain?

Was Raghuram Rajan playing the victim?

This is the context that lends significance to the comment that Raghuram Rajan, the Governor of the Reserve Bank of India, made in end-January. He said that global policy co-ordination between the developed world and the developing world had collapsed. He did not stop there. He said more. If they were forced to adjust to the fickle loyalties of global footloose capital without the developed world lending support, he said that developing countries would make the necessary adjustments on their part but the developed world might not like those adjustments.

That provoked a flurry of opinion pieces. The most pointed critique of his remarks came from Dani Rodrik and Arvind Subramanian in Bloomberg. They said that emerging economies stood to gain nothing from “playing the victim” and that the Fed would always stay focused on domestic economic goals. Their argument goes like this: The United States abandoned its commitments under Bretton Woods agreement when it ended the gold convertibility window in the 1970s and let its exchange rate float. (Well, it abandoned its obligations much before that – in the 1960s. That is beside the point.) Hence, it is not possible to expect the US to behave responsibly towards the international community. That is specious. Global reserve currency issuers have higher obligations.

The United States abandoned its obligations but not its privileges of being a global reserve currency. It had sought to enjoy the best of both worlds – all rights with no responsibility. It has undertaken political and economic missions, it had crafted international trade treaties and it had used its powers of suasion, coercion and diplomacy to ensure that the US dollar remained the pre-eminent global transaction currency and global reserve currency. Hence, it does have an obligation – whether legally binding or not – to be sensitive to the fallout of its policies on other countries.

It is nobody’s case that emerging economies are not responsible for their problems. Post-crisis, they believed that investments would keep flowing into emerging economies and that their day under the sun had arrived to stay permanently. But, hubris is global. The developed world was in thrall to the bogus theory of “great moderation” before the bust of 2008 laid that claim to rest. To date, the lesson has gone unheeded, however. There is a belief – partly out of the compulsion that the room for fiscal manoeuvre is limited and partly out of the false faith in the power of the central banker – that monetary policy, acting alone, can restore sustainable economic activity. The next crisis will prove them wrong again but it will be “rinse, lather, repeat” on monetary policy in the US.

Further, condescending references to political economy constraints in emerging economies do not help and smack of shameless hypocrisy. It is not as though emerging economies have uniquely bad policy makers or suffer from uniquely venal and dysfunctional politics. The United States bailed out automakers in the crisis. There was the famous “cash for clunkers” policy. European countries emulated it. The US just let one major investment bank fail and bailed out the rest including making whole private sector claims on AIG – onshore and offshore. The Dodd-Frank legislation is making slow progress, if at all and financial institutions are seeking innovative ways to neutralise the Volcker rule. The revolving door between Wall Street and Washington continues. The US Congress could not agree on effective and targeted fiscal stimulus. The United Kingdom had offed subsidies to first-time homebuyers. The Finnish government faced heavy protests in 2008 because it dared to propose raising the retirement age.

Hence, to expect technocrats and policymakers in emerging economies to get past political obstacles and pursue a rational and painful reform path – especially when times are good – is to demand of them a feat that policymakers in the West had not attempted. Indeed, Raghuram Rajan had referred precisely to these issues in the Andrew Crockett Memorial Lecture he delivered in June 2013. His remarks on the collapse of global policy co-ordination, in fact, should be seen in the context of his remarks made then about the large spillover effects from unconventional monetary policies pursued in the West, the unproven efficacy of macro prudential measures, the difficulty of persuading economic participants to practise delayed gratification when times are good (examples: advocating tight fiscal policy when revenues are booming and persuading financial market participants to project and assess risk over a cycle rather than a given point in time).

He had also addressed specifically the issue of tapering in his speech. The concern is not about asset prices that decline when the Fed tapers. It is about the leverage that has accumulated before that. Both borrowers and lenders fail to assess risk over the complete cycle of asset purchases and their eventual tapering by the Federal Reserve. But, borrowers bear the brunt of the risk re-assessment when the cycle of asset purchases ends as the legal rights and obligations of lenders and borrowers are different.

Second, asset purchases are only one part of the unconventional monetary policy that the West has pursued. The other is “forward guidance”. Interest rates are going to remain low for a considerable period ahead. The Federal Reserve has repeated more than once in its policy meetings that interest rates are expected to remain at extremely low levels well after the unemployment rate has breached 6.5 percent on its way down. The new Fed chairperson reiterated that too in her testimony. On 12 January, the Bank of England confirmed that it was behind the Federal Reserve in this asymmetric attitude towards restoring normal monetary policy. Once financial markets get over their obsession with tapering, capital flows into emerging economies will resume as liquidity will flow plenty under zero interest rates. What will emerging markets do or what can they do?

Enduring concerns about financial globalisation

In a recent piece Dani Rodrik suggests that emerging economies strike the right balance between the real economy and finance. Rodrik reckons that developing economies have to choose between maintaining strong prudential controls and insuring themselves through accumulation of large foreign exchange reserves. Of course, they can do a bit of both. Both are market distorting and may not deliver the on goals they pursue. Prudential controls can be circumvented. Raising domestic interest rates will simply push borrowers to take on riskier foreign loans in a world of unrestricted capital flows. This is what has happened after the 2008 global crisis. The relevant cost of capital in a world of unconventional monetary policies and free capital flows is not the domestic rate of interest. That leads us to confront the bizarre reality that the world of boom-bust capital flows has presented the developing world with: pro-cyclical monetary policy (cutting rates during boom times and raising them in busts).

Rodrik homes in on the real underlying cause of the policy dilemmas that emerging nations face when he points to financial globalisation. However, he apportions blame for the excessive financial globalisation that has occurred in the last two to three decades equally on all governments. That isn’t persuasive. As an experienced policymaker put it, the experience of developing countries is different – advanced economies are the dispensers of rules of global monetary and financial market regimes and emerging economies are mostly helpless followers.  Financial globalisation has left policymakers in the developing world with few meaningful options. Given the second-best policy setting cards they had been dealt, market distorting responses from emerging policymakers may well be inevitable. (Andrew Sheng of the Fung Global Institute has said that the world has too much QE and too much complexity in macro prudential regulations. This is an example of where the former begot the latter.) However, the real worry is that even these second best options may not be available to them.

The tilted playing field

Kevin Gallagher of the Boston University points out that developing countries perhaps do not appreciate the dangers that lurk in the bilateral trade and investment treaties they pursue. He had spelt them out in a paper published in October 2013 in greater detail. The investment clauses of the proposed Trans-Pacific Partnership (TPP) and other Free Trade Agreements (FTA) negotiated with the US are based on the 2012 US model Bilateral Investment Treaty (BIT). This does not provide for use of “Capital Flows Management” (CFM) measures in times of crisis.

Where safeguards exist in BIT, they are modelled on standard Generalised Agreement on Trade in Services (GATS) clauses. GATS Article XII provides for adoption of measures in times of “Balance of Payments” difficulties. But, these are restricted to capital outflows and not inflows.  Further, these safeguards must also comply with WTO norms of being non-discriminatory, temporary and necessary. The burden of proof on all this rests with the respondent and not the complainant. Further, ‘prudential’ remains undefined in GATS. Importantly, the United States’ model BIT provides for investor-state dispute settlement rather than confining dispute settlement to between states. The latter would limit the possibility of cases being filed related to sensitive public policies such as CFM.

In his presentation at a conference hosted by India’s Centre for Advanced Financial Research and Learning (CAFRAL) in mid-January, Kevin Gallagher advocates permanent countercyclical measures on cross-border finance, coalition building among emerging economies, building alternative institutions and leveraging them at International Financial Institutions and evoking the collective memory of financial crises.

It is instructive that all the caveats and vagueness found in GATS and applied in BIT appear to rule out countries instituting permanent counter-cyclical macroprudential measures. This seems to run counter to the widespread belief that international financial institutions in general and the International Monetary Fund, in particular, have acknowledged the usefulness of deploying these measures alongside conventional monetary policy and fiscal policy measures. Paulo Nogueira Batista, Executive Director Brazil, International Monetary Fund, participating at the CAFRAL conference mentioned above disabuses us of that naïve notion. He offers a brutally realistic assessment of entrenched views in favour of liberal capital flows at the IMF:

“Well compared to this rather low pre-crisis standard, the new institutional view represents some progress. For example, measures on inflows and outflows are now seen as advisable in certain circumstances, and the institutional view of the IMF explicitly states that there is no presumption that full capital account liberalisation is an appropriate goal for all countries at all times. I think that’s quite a significant step forward. Observe that the IMF also recognises controls on outflows as potentially important in a crisis situation, in crisis prevention and in crisis management…

…This is pretty much as far as the Fund’s intellectual flexibility goes. The recognition of the role of capital account management is qualified by a number of statements that effectively downplay the role that these measures can have. For example, capital flow measures are referred to as temporary, implying that they should be used for short periods… the IMF’s approach suffers from lack of balance in at least three major respects.

First, the Fund emphasises the benefits of capital flows for recipient countries, with insufficient consideration of their costs and risks. Whatever recognition of cost and risks you do find in the institutional view was inserted mostly after great insistence from some emerging market directors in the teeth of heavy resistance. Second, the institutional view of the Fund has a focus on recipient countries with much less attention to source countries; the so-called push factors are not sufficiently dealt with, in my opinion. Third, there is a lingering overall bias against capital flow measures, especially capital controls. They are admitted in the tool kit, so to speak, but with many hesitations and restrictions.”

A fellow participant at the CAFRAL conference, Ms Stephany Griffith-Jones, had earlier made a rather useful suggestion for source countries like the US. In a paper presented in December last year, she had suggested measures that the US could have usefully deployed to discourage carry trade flows flooding emerging economies. After all, the purpose of unconventional monetary policy was to encourage domestic lending and risk-taking and not to send capital overseas. Or, is it? In recent years, the trade surplus on services for the United States has quietly reached new highs and is now very sizeable (see chart). It will be interesting to examine if the causality runs from the surplus in services trade to US stance in trade negotiations or the other way around.

US Trade Surplus in Services – high and rising

Graph 1

At the concluding session in the CAFRAL conference featuring three ex-Governors of the Reserve Bank of India, Bimal Jalan, one of the three former Governors participating, said that the current global monetary regime has no rules of the game and called for a new Bretton Woods agreement. The starting point of the journey and the path to that destination are far from clear as is the global acceptability of the eventual arrangement that would emerge from a re-negotiated agreement. The latter is an important factor that impedes the emergence of an alternative to the US dollar. Nations, as humans do, feel that the known devil is better.

Separately, Mr Batista had expressed a hope that the future would see a more balanced approach at the IMF towards liberal capital flows and capital-flows management and he also hoped that it would not take another international financial crisis to arrive at that balance. However, that some incremental progress occurred in the views of the Fund on capital flows only due to the global crisis of 2008 is worth remembering. Therefore, the one thing that binds Mr Jalan’s call and Mr Batista’s hope is that it may take several more crises before more lasting changes occur.

Selected paragraphs from Raghuram Rajan’s Andrew Crockett Memorial Lecture in June 2013

“For the receiving country, it is unclear whether monetary policy should tighten and attract more inflows, or be accommodative and fuel the credit boom. Tighter fiscal policy is a textbook solution to contain aggregate demand, but it is politically difficult to tighten when revenues are booming, for the boom masks weakness, and the lack of obvious problems makes countermeasures politically difficult. Put differently, as I will argue later, industrial country central bankers justify unconventional policies because politicians are not taking the necessary decisions in their own countries – unconventional policies are the only game in town. At the same time, however, they expect receiving countries to follow textbook reactions to capital inflows, without acknowledging that these too may be politically difficult. Prudential measures, including capital controls, to contain credit expansion is the new received wisdom, but their effectiveness against the “wall of capital inflows” has yet to be established. Spain’s countercyclical provisioning norms may have prevented worse outcomes, but could not prevent the damage that the credit and construction boom did to Spain.

One might think that countries that have complained about unconventional monetary policies in industrial countries should be happy with exit. The key complication is leverage. If asset prices simply went up and down, the withdrawal of unconventional policies should restore status quo ante. However, leverage built up in sectors with hitherto rising asset prices can bring down firms, financiers, and even whole economies when they fall. There is no use saying that everyone should have anticipated the consequences of the end of unconventional policies. As Andrew Crockett put it in his speech, “financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle.”

The reality may be that the wall of capital dispatched by sending countries may far outweigh the puny defences that most receiving countries have to offset its effects. What may work theoretically may not be of the right magnitude in practice to offset pro-cyclical effects, and even if it is of the right magnitude, may not be politically feasible. As leverage in the receiving country builds up, vulnerabilities mount, and these are quickly exposed when markets sense an end to the unconventional policies and reverse the flows.”

Photo: petter pallendar