EXECUTIVE SUMMARY HOW TO RESPOND TO CAPITAL INFLOW EPISODES 1. Do nothing and allow/accept the currency appreciation accompanying these inflows 2. Unsterilized FX intervention to prevent a nominal appreciation 3. Sterilized intervention to prevent a nominal and real appreciation 4. Controls on inflows of foreign capital (capital controls) 5. Fiscal tightening and public asset and liabilities management 6. Macro-prudential regulation/supervision of banks and financial institutions 7. Massive large-scale long-term sterilized FX intervention SUMMARY OF THE POLICY IMPLICATIONS: DIFFICULT POLICY TRADEOFF IMPLICATIONS FOR ASSET PRICES IN EMERGING MARKET ECONOMIES EXECUTIVE SUMMARY Capital flows to emerging market economies (EMs) have been going through a cycle of boom and bust for decades. In the past year, especially since the middle of 2010, we have seen another boom with massive flows of capitalFDI, portfolio equity investments and fixed-income investmentsgoing to EMs, especially those perceived by market participants as having stronger macro, policy and financial fundamentals. The question is how should policy makers respond to these inflows? Do nothing and allow their currencies to appreciate and thus risk real currency overvaluation, loss of competitiveness and growth? Aggressively intervene to prevent appreciation in an unsterilized way and thus feed monetary and credit growth, economic overheating, inflation and asset/credit bubbles? Intervene in a sterilized way and thus feed further capital inflows as the interest rate differentials and undervaluation that trigger the inflows are maintained? Impose capital controls on short-term money that affects the short-term/long-term composition of inflows, but risks not preventing appreciation as the controls dont affect the overall amount of inflows? Tighten fiscal policy to reduce domestic rates and inflows at the risk of feeding further inflows if fiscal discipline is associated with lower sovereign risk? Impose credit control and macro-prudential supervision and regulation of the banking system to reduce the chance of credit and asset bubbles at the risk that the inflows will bypass the banking system and go directly to domestic capital markets, and thus still feed asset bubbles? Massively intervene for a long time in a sterilized way to satisfy the long-term secular demand by international investors for the assets of EMs?
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These difficult policy choices and trade-offs are driven by one of the key principles of international macrofinance: the Inconsistent Trinity (or the Impossible Trinity). This principle says that economies can never have all three of the following features at the same time: fixed or semi-fixed exchange rates, an independent monetary/credit policy and perfect capital mobility unconstrained by capital controls. Only two of these three objectives can be achieved at any one point in time: if there are no capital controls and a country wants an independent monetary policy, it needs to give up on fixed exchange rates in favor of a flexible regime; if there are no capital controls and the policy makers want fixed or semi-fixed exchange rates, they lose monetary/credit policy independence; and, if policy makers want to maintain monetary independence while maintaining fixed or semi-fixed exchange rates, they need to sacrifice capital mobility and use capital controls (on inflows or outflows, depending on whether they are trying to manage a capital inflow episode or a case of capital flight). HOW TO RESPOND TO CAPITAL INFLOW EPISODES So, how should policy makers respond to these massive inflows and prevent them from destabilizing the domestic economy and financial markets? Before considering specific policy options, one should note that such inflows are driven both by short-term cyclical factors (interest rate differentials and a wall of liquidity chasing assets as more quantitative easing in weakly growing advanced economies becomes the norm, with risk-on periods of falling global risk aversion) and longer-term secular factors: long-term growth differentials relative to advanced economies; global investors who are less biased toward their home markets, with related diversification to EMs and higher long-term expected returns on EM assets; the expectation of long-term nominal/real appreciation of EM currencies; and the realization that financial and sovereign debt crises can occur in advanced economies as well as in EMs, and therefore that volatility in advanced economies can be as high or higher than in EMs. The long-term secular factors are important as investors in advanced economies are diversifying their portfolios internationally and discovering that they are long-term underweight in EM assets. Thus, many of these inflows are not the classic short-term hot money inflows that can flow out within a few months, but rather are usually permanent and long term. The policy options for EMs receiving these inflows can be organized into seven groups. 1. Do nothing and allow/accept the currency appreciation accompanying these inflows The first and initial option for policy makers is to do nothing and allow whatever nominal and real appreciation that is triggered by such inflows. The arguments for preventing this nominal appreciation are well known: if the appreciation is excessive, the currency could become overvalued in real terms and the external balance worsen excessively, with a rapidly shrinking current account surplus or even a growing current account deficit. The resulting loss of competitiveness would hurt economic growth and eventually even trigger a financial crisis if the current account deficit becomes excessive and unsustainable. But there are also plenty of counter-arguments that suggest that a significant nominal and real appreciation is necessary, driven by fundamentals and desirable. First, the currency appreciation could be driven by fundamental factors such as a previously undervalued currency that had weakened too much in a previous financial crisis or episode of global risk aversion. Or the country may be running a large current account surplus (possibly also driven by currency undervaluation) that leads to fundamental appreciation pressures on the economy. Or the countrys currency may be strengthening as its terms of trade are improving following, for example, a rise in the real price of the commodities that it exports.95 Morton Street, 6th Floor New York, NY 10014 TEL: 212 645 0010 FAX: 212 645 0023 7th Floor, The Place 174-177 High Holborn London WC1V 7AA TEL: 44 207 420 2800 FAX: 44 207 836 5362
Second, nominal and real appreciation can be desirable as it: leads to a reduction in inflationary pressures; reduces the cost of imported foreign currency-denominated commodities and intermediate inputs (with respect to commodities, this is mainly about their currency value relative to the U.S. dollarthe currency in which most commodities are traded globally); increases the purchasing power of domestic importers, especially households; and can even improve the countrys terms of tradeand thus increase real incomeby reducing the relative price of imported goods. Third, if the nominal appreciation that these inflows induce is prevented via sterilized intervention in the FX markets, capital inflows driven by carry trade considerationsinterest rate differentialswill keep on coming and exert further upward pressure on the currency that is expected to appreciate. If, instead, the currency is allowed to appreciate from an undervalued level to a fairly valued level, the inflows will stop and the appreciation pressures will subside as the necessary, desirable and fundamentally driven appreciation is accommodated rather than resisted. It is better to let a step or gradual appreciation occur until the currency is not regarded by global investors as undervalued to ensure that capital inflows stop coming. Moreover, if the nominal appreciation is resisted through unsterilized FX intervention, the resulting fundamental real appreciation of the currency will occur via a rise in inflation rather than a nominal appreciation (as in Mexico, Brazil and Argentina in the 1990s or Russia in 1990s and again in the 2000-08 period). In the long term, you cannot fight a fundamental real appreciation. Fourth, those capital inflows and the induced alteration of nominal and real exchange rates will change the domestic allocation of resources toward booming sectorssuch as commodities if an increase in the price of commodities is the initial driver of the capital inflows and currency strengtheningand away from declining sectors (such as other export sectors or import-competing sectors subject to import competition). Fighting this necessary and desirable reallocation of resources that will occur anyhow in the long term to preserve the competitiveness of declining sectors may be a mistake as markets and price signalsthe capital inflows and the resulting appreciationsuggest that a reallocation of resources is desirable, optimal and eventually unavoidable. However, there are many arguments against doing nothing and allowing currencies to appreciate. First, markets are often wrong and capital inflows may be excessive and driven by factors that do not depend on fundamentals; they can be driven by irrational exuberanceinvestors temporary fads for EMs that eventually get reversed. Second, if flows driven by factors other than fundamentals lead to excessive appreciation, the economy will eventually be damaged: the current account balance will worsen; there is a resulting loss of competiveness; and growth could slow sharply. Third, in some extreme cases, excessive inflows may eventually lead to excessive outflows and financial crises: if the currency becomes so overvalued that the current account turns into a large and growing deficit that is increasingly financed with short-term and foreign currency debt, a financial crisis driven by an unsustainable current account deficit and an external debt sustainability problem could eventually take place (see Mexico in 1994-95, East Asia in 1997-98, Turkey and Argentina in 2001 and many other episodes of financial crises in EMs). Fourth, excessive real appreciation driven by the rise in the price of the export goods of a countrytraditionally commodities and resources in abundant supply in the countryleads to a Dutch Disease: non-traditional exports such as manufacturing goods and other commodities not subject to a price increase lose competitiveness and are crowded out. Thus, import-competing sectors can be destroyed and non-traditional exports can also be95 Morton Street, 6th Floor New York, NY 10014 TEL: 212 645 0010 FAX: 212 645 0023 7th Floor, The Place 174-177 High Holborn London WC1V 7AA TEL: 44 207 420 2800 FAX: 44 207 836 5362
damaged. While one could argue that the decline of such sectors may be desirable if relative prices and flows of capital suggest reallocation of resources toward sectors such as commodities whose prices are rising and away from declining sectors, this reallocation can become problematic: if the inflows are partly a bubble not driven by long-term fundamentals, you end up destroying sectors that would have been viable if that excessive real appreciation had not occurred. Also, the economy becomes less diversified if most of the production gets concentrated in the booming commodity sectors and is thus then at risk of long-term output volatility if the countrys terms of trade become hostage to the whims of externally determined commodity prices. For example, the nominal appreciation of the Brazilian real and Chilean peso today is partly justified by the rise of agricultural, oil and energy prices (for Brazil) and the rise of copper prices for Chile. But, based on a number of indicators, the real exchange rate of Brazils currency is already way overvalued and the Chilean peso is becoming overvalued. Thus, import-competing sectors and non-commodity manufactured goods export firms in Brazil are hurting, while in Chile, non-traditional exportersof wine, salmon and other agricultural goods may be pushed to the brink by the excessively strong currency. If the inflows are excessive and the real appreciation excessive, the damage to or destruction of these other traded goods sectors willin the medium to long termdamage the economy, especially if it is driven by excessive short-term inflows that cause excessively overvalued currencies. Once certain traded goods sectors have declined or are gone, the damage will be permanent as such sectors will not come back. Certainly, it would not be in the interest of Chile to become a quasi banana republic, producing only a single highly volatile commodity such as copper. It is also important to emphasize the difference between a diversified commodity-producing nation versus a non-diversified one. Brazil, as an example, is the global leader in sugar production, a large and diversified net exporter of metals and foodstuffs and a small net importer of energy products. It benefits overall from relative commodity price movements, as energy has rallied only slightly in the past year against metals and agricultural prices. Alternatively, Mexico benefits marginally from higher oil prices, but is a large net importer of higherpriced agriculture-related commodities. Leaders that fail to diversify their economies could see investments succeeding largely because their rising currency stunts growth in other sectors such as manufacturing and tourism. The end result is that they are more susceptible to boom and bust cycles, high income inequality and labor unrest. Also, suggested policy responses other than preventing a currency appreciationsuch as allowing these exporters to hedge the currency risk or helping them by providing them with lower cost of capital or quasiexport subsidiesare merely palliatives or band aids that dont prevent a long-term decline triggered by excessive appreciation: currency hedging cannot hedge against long-term currency movements and long-term changes in relative prices; subsidies on the cost of capital are too small to make a difference; and quasi-export subsidies are constrained by the fact that policy actions closer to export subsidies are severely restricted by WTO rules. But, what if such inflows and appreciation pressures are persistent and long term, rather than short term? Should the reallocation of resources from declining sectors to booming sectors not be facilitated, rather than prevented or resisted? Over a long time period, countries like Korea, Taiwan and Japan experienced tremendous appreciation as they transitioned from being relatively poor sta...