The fifth anniversary of the collapse of Lehman Brothers, the epicentre of the 2008 global financial crisis (GFC) is a reminder that financial markets don’t always work well. The current angst over capital flow reversals to the emerging economies illustrates another aspect of malfunction. There is, however, one important difference: we now see clearly what went wrong in the years leading up to the GFC, with the ‘light touch’ regulatory approach a key mistake. We also see how the problems might be fixed through more assertive regulation.
In the case of disruptively volatile capital flows, however, there is no effective global authority exercising oversight. The standard prescription is for masterly inactivity.
During the inflow phase when exchange rates were being pushed up, Brazil was vocal in complaining about ‘currency wars’. The reverse phase since May has silenced this talk, but has left some of these economies whip-sawed. Brazil’s inflation-adjusted exchange rate (a measure of its international competitiveness) rose around 25 per cent in the initial period of the US Fed's quantitative easing, and has fallen the same amount since May.
It’s not just the sudden fall in exchange rates that does damage. Gloomy talk in financial markets infects the economic climate. Every commentator excitedly recalls the disastrous 1997 Asian crisis. They draw attention to policy deficiencies that went unremarked during the inflow phase. Confidence is lost, company balance sheets are distorted and ‘animal spirits’ are deflated.
What might be done?
Both the US and Japan have asserted that their extreme monetary policy settings are in fact in everyone’s interests as they foster domestic growth, which will have international spillover. This defence has been endorsed by the G7 (conveniently, without emerging economies) and the IMF. This narrative has even been carried over to the G20; there were a couple of passing references to ‘volatile capital flows’ in the all-embracing St Petersburg G20 Summit communique, but the issue has been effectively ignored.
Emerging countries are on their own. Until recently, the standard advice urged them to open their capital accounts for unrestricted flows and to move quickly to a freely floating exchange rate. The promise was that this would give the recipients the benefits of participating in global capital markets.
Emerging economies have always been suspicious of this advice. Their ‘fear of floating’ seems well founded. But even as the IMF has belatedly come to accept that foreign flows may sometimes be disruptive, it offers a limited range of policy measures. What might these countries do?
First, there is foreign exchange-market intervention. This may be effective, but only in the right context. The 2008 experience in Korea and Indonesia shows that markets become agitated when they see foreign exchange reserve levels falling. In the context of a free float, official intervention is taken as a sign of panic.
What about calling for outside support to supplement intervention capacity? Any suggestion that a country might call on IMF assistance is off the policy agenda in East Asia due to memories of the 1997 crisis, and would be a measure of desperation elsewhere. Current IMF programs in the European periphery remind financial markets that this is the prelude to a debt rescheduling. No sensible policymaker is going there. Drawing on the Chiang Mai Initiative involves the same problem: submitting to IMF conditionality. One low-profile measure is available: bilateral swaps with foreign central banks, which seemed to stabilise the situation in Korea in 2008.
But the real answer is stoic self-reliance: good domestic policies, no matter how hard this is.
Paradoxically, one central element is to avoid drawing heavily on global financial markets. Don’t run a significant current account deficit or clock up much external debt. In the good times global markets will ply an emerging economy with funding that the same intermediaries will later judge to be excessive. Thus a policy of restraint in the good times might involve discouraging short-term capital inflows through Chilean-style taxes and restrictions on inflows.
For emerging countries without deep financial markets or a well-established exchange rate norm, there is also a good case for consciously abandoning the free-float mantra, allowing the exchange rate to move but only within a broad band. Outside this band, the exchange rate has clearly gone beyond its underlying equilibrium. Exchange rate intervention around the edges of this band can no longer be seen as a panic response to volatile capital flows, but rather as a pre-determined stabilising response. Singapore has for decades demonstrated the benefits of this approach.
In this approach, holding substantial foreign exchange reserves shouldn’t provoke international criticism, as it does at present. Domestic reserves could be backed by permanent swap agreements with foreign central banks. Chiang Mai resources could be added in, though only if the current stigma-laden IMF involvement is removed.
Emerging economies are small relative to the huge flows of global capital markets. They should develop more interventionist exchange rate policies and establish routine practices of discouraging short-term capital inflows whose fickle nature means that they are of no benefit. Complaints to international forums about currency wars will be futile. It’s every country for itself.
Originally published by The Lowy Institute publication The Interpreter. Republished with permission.