By Kevin P. Gallagher*
Brazilian President Dilma Rousseff’s warning to U.S. Fed Chairman Ben Bernanke in 2012 – that his monetary-easing policies were creating a harmful tsunami of financial flows to emerging markets – was spot-on. U.S. growth and interest rates have been appreciating currencies, causing asset bubbles, and exporting financial instability to the developing world. Brazil and other emerging-market countries may soon be facing capital flight and exchange rate depreciation that could lead to financial instability and weak growth for years to come. From 2009 to 2013 countries like Brazil, South Korea, Chile, Colombia, Indonesia and Taiwan all had wide interest rate differentials with the U.S. and experienced massive surges of capital flows. The differential between Brazil and the U.S. was more than 10 percentage points for a while. According to the latest estimates by the Bank for International Settlements (BIS), emerging markets now hold a staggering $2.6 trillion in international debt securities and $3.1 trillion in cross-border loans – the majority in dollars.
Now the tides are turning. Many emerging market growth forecasts are continually being revised downward. China’s economy is undergoing a structural transformation that necessitates slower growth and less reliance on primary commodities. The prices of oil and other major commodities are stabilizing or declining. As growth and interest rates pick up in the United States, the dollar gains strength – and emerging market currencies fall. Brazil’s real hit a 10-year low last week, down to 2.87 to the dollar, amid continuing predictions of zero growth for the country this year.
The traditional tools for weathering the storm may not be available or enough for developing economies. Floating exchange rates and the resulting depreciation can cause the debt burden on firms and fiscal budgets can bloat overnight, especially in a lower growth environment. Increasing competitiveness would have helped boost exports, but an IMF study shows that Latin America failed to use one of the biggest commodity windfalls in its history to invest, hindering competitiveness to ride out the tsunami in short-term inflows. Local bond markets help, but most debt is indeed in dollars, and most local debt is held by foreigners who are always the first to dump such debt. Interest rate hikes can also be dangerous; they don’t reverse flight and can choke off what little growth there is to be had in a downturn. Depleting foreign exchange reserves doesn’t always work; increasing debt could bring financial instability but threaten prospects for growth and employment. Having no good options, emerging-market and developing countries may need to resort to regulating the outflow of capital alongside these other measures. Such moves have traditionally been shunned by international institutions and capital markets, and new U.S. trade agreements such as the Trans-Pacific Partnership have stripped out balance-of-payment exceptions that allow nations to regulate capital. But new research in cutting edge of economics by the IMF and others now justifies such measures to prevent or mitigate a full-blown crisis. If we have learned anything from the global financial crisis since 2008, it is that nations need as many tools at their disposal to prevent and mitigate financial instability. Instability anywhere can lead to instability everywhere, so we need all tools and hands on deck.
February 19, 2015
* Kevin P. Gallagher is an associate professor of global development policy at Boston University’s Pardee School for Global Studies, where he co-directs the Global Economic Governance Initiative. His new book is Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance.