Capital flows offer countries huge potential benefits, but they can also be very dangerous. Too much capital in emerging economies can overwhelm badly regulated systems, and sudden stops can cause jarring financial crises. To review the experience with these types of crises, the IMF held an Economic Forum on November 7 at the conclusion of its Fourth Annual Research Conference (see page 365). Panelists were Agustín Carstens (IMF Deputy Managing Director), Jeffrey Frieden (Professor, Harvard University), Peter Garber (Global Strategist, Deutsche Bank), and Morris Goldstein (Senior Fellow, Institute for International Economics). Zanny Minton-Beddoes (The Economist) moderated.
Drawing on his previous experience in the Mexican Finance Ministry, the IMF’s Agustín Carstens opened the forum by citing six lessons that countries can follow to avoid having capital flows interfere with macroeconomic performance.
• Develop internal sources of finance. Countries that do this well, Carstens said, attract complementary, good-quality capital flows from abroad. But how can countries develop their domestic financial systems? By concentrating on the fundamentals—solid macroeconomic management, good rule of law, and effective financial supervision and regulation, with an emphasis on the quality of human capital needed.
• Be extremely vigilant about the health of countries’ financial systems%. The biggest risk that a country in a banking crisis faces is a weak financial system. There is no greater deterrent to development, Carstens noted, than having a derailed banking system, which can generate huge capital outflows.
• Exercise great care in the use of derivatives and indexing as instruments to entice or maintain capital flows%. These instruments can be hazardous for the economic health of a country, particularly its public finances. When a country is under balance of payments pressure, there is the temptation to substitute gimmicks for good policymaking. But there is no substitute for decisive macroeconomic measures, and, sooner rather than later, the abuse of indexing and derivatives will come back and eat countries alive.
• Be transparent%. Many governments have tried to manage information as a policy instrument. But markets are now very sophisticated and the space for abusing the management of information is long gone.
• Self-insure against shocks and volatilities in capital markets by building up reserves to be able to service debts%. This holds even if countries have a floating exchange rate regime.
• Pursue foreign direct investment (FDI)%. FDI can bring capital, technology, and employment, but having a physical plant in a country will not forestall the outflow of capital in case of instability.
Morris Goldstein of the Institute for International Economics built on Carstens’ points, stressing that the liberalization of capital flows needs to be phased in accordance with the health and resilience of the country’s domestic financial system. To explain his point, he cited the “trilemma” now playing out in China: high rates of capital inflows, significant expansion of bank lending, and an overheating economy (see discussion of trilemma, page 365).
According to Goldstein, the renminbi is overvalued by about 15-25 percent. One solution to the trilemma would be to allow the currency to float freely and to completely open the capital account. But, he said, the Chinese authorities are justifiably concerned that if they open the capital account and if there were bad news about the banking system, this could lead to large-scale capital flight and a large depreciation.
A better way to solve the trilemma, Goldstein argued, is for China to reform its exchange rate regime by switching to a basket peg with equal weights for the dollar, the yen, and the euro; by revaluating the exchange rate by 15 percent to 25 percent immediately; and by widening the exchange rate band from less than 1 percent to, say, 5 percent to 7 percent. In addition, China should open its capital account and allow the renminbi to float after it gets its banking system on a sounder footing. When countries have to worry about their banking system, they don’t have a trilemma but a quadrilemma.
More generally, Goldstein pointed out two major problems associated with sudden stops in capital flows and exchange rate volatility: too much public debt and currency mismatches. In the past, the international community has not been conservative enough about what is a safe or sustainable ratio of public debt. We used to think that 50 percent or 60 percent of GDP was not such a big number, he said, but events have shown that it is. The IMF needs to be tougher about making debt sustainability a key condition for its lending.
Currency mismatches are at the heart of emerging market vulnerability to sharp exchange rate depreciation and should be higher up on the priority list for reform of the financial architecture, Goldstein said. Currency mismatch variables have proved to be one of the better performing leading indicators of currency and banking crises. The IMF should therefore regularly publish data on currency mismatches at the economy-wide and sectoral levels and comment on mismatches it regards as excessive. It should also make the reduction of currency mismatches a condition for its loans in cases where they are deemed to be too large.
Peter Garber of Deutsche Bank gave a provocative view of what the global economy is like now. To explain the emergence of global imbalances, notably between Asia and the rest of the world, particularly with the United States, he divided the world into three capital account zones.
The first zone is where capital flows are driven primarily by the normal risk-return calculations of the private sector. The second zone is where capital flows are driven more by an export-led development strategy. And the third zone acts as a buffer that absorbs capital flows for a price. So where does this fundamental disequilibrium come from? According to Garber, it stems from the enormous excess supply of labor in Asia now waiting to enter the modern global economy, with the exchange rate acting as a valve that controls that rate of entry. To explain how this has come about, Garber used the following analogy. Fifteen years ago there were two isolated planets that were circling the sun. One of them had three major capital-rich industrial regions—Europe, the United States, and Japan—and a periphery of small countries more or less in a fully employed equilibrium with floating exchange rates and capital mobility. The other planet was a communist/socialist world that had large amounts of labor and misallocated and valueless capital. Suddenly, they were pushed together to form one large global market economy. This created a system with massive global unemployment.
There are two ways to correct this imbalance, Garber said. First, by encouraging the growth of internal demand and the importation of capital in the underemployed regions. Second, by running an export-led development program with controls and subsidization of the export sector.
Asia, in particular China, Garber said, chose the latter route, undervaluing exchange rates and exporting capital to the richer zone. But since the export sector is more labor-intensive than the rest, correcting this imbalance by appreciating the exchange rate would, in China, eliminate about half a million jobs in the export sector. This would hurt China’s growth prospects and thus create an enormous political problem. Garber said that explains why China will not appreciate its exchange rate.
Political and domestic factors
Jeffrey Frieden of Harvard University, a specialist in the politics of international economics, explained why countries act and react the way they do. He started by pointing out that there are two dimensions of capital flow cycles that do not receive much attention: the domestic aspect—that is, what does it look like from the standpoint of a country experiencing a capital flow cycle—and political economy factors.
At the national level, capital inflows create a domestic economic expansion, which is associated with a real exchange rate appreciation. But as the cycle continues, some problems begin to surface. Producers of tradables complain about their loss of domestic market. There are also problems with currency mismatches and concerns about the sustainability of the exchange rate. All these problems, Frieden said, lead to the inevitable end of the cycle, in some cases, with a crash.
How can countries respond to this kind of cycle? One option is sterilization and concerted efforts to avoid an appreciation. But, as mentioned by Garber in the case of China, countries oftentimes attempt to keep the exchange rate relatively weak. Another alternative is to make the exchange rate relatively flexible during the cycle and not wait until there is some sort of massive currency crisis to let the exchange rate go. But, Frieden said, these alternative roads are rarely taken.
Why is delay so common? According to Frieden, there is an underlying political tension that affects the policymaking during these cycles. On the one hand, there is significant resistance to a depreciation in the upswing of a cycle from consumers, especially the middle classes. On the other hand, tradables producers face even greater competitive pressures as a result of a real appreciation. So as the cycle continues, policymakers face conflicting political pressures from different groups in society.
One particular group is consumers. In the run-up to an election, Frieden said, the last thing countries want to do is engineer a devaluation or a depreciation that is going to harm pivotal consumer groups. Governments, he said, are four times more likely to oversee a large depreciation—that is, one exceeding 25 percent—in the six months after an election than they are in the six months before an election.