This post was meant to have been written a couple of months ago, as a follow-up to this piece, but as I am easily distracted – especially by shiny objects – the draft was set aside and ultimately forgotten. Forgotten, that is, until the IMF went ahead and published their take on the matter. Since the IMF report is an Official Publication and contains things called “Granger causality tests,” and other such statistical chicanery, I will leverage from it quite heavily:
The issue at hand is the increase in capital flows from rich countries to “receiving” economies, and how that will affect the latter. Starting in 2003, but really expanding from 2007-present, the Liquidity-Time Explosion (that’s my term, not the IMF’s) resulted in large outflows of capital from the G4 (US, UK, then later Japan and the Euro-area). This was the result of interest rates in those economies hitting rock bottom, or close to it. Cheap money in the G4 (if one can get any) is logically channelled from the low-interest rate environment to economies that have higher rates of return.
The receiving economies are mainly emerging markets in Asia, emerging Europe, Latin America, the Middle East and Africa. To be clear, capital inflows can be a very good thing for these countries as it helps fund domestic investment and long-term growth. It especially makes sense for capital to be flowing to countries that have rosy growth prospects, which is the case for many emerging markets.
However, the IMF looks at the rapid rate of asset price growth in some emerging markets recently and asks the following, crucial question: “Are capital flows into receiving economies primarily driven by the countries’ strong economic fundamentals and, therefore, likely to remain stable over the medium to long term, or are they primarily driven by the abundant global liquidity?”
Looking at the data, the IMF concludes that, yes, global liquidity is playing a significant role. But the effect is not uniform: the type of exchange rate regime in the receiving economy plays an important role in determining how it is affected: “… the higher the flexibility of the exchange rate, the lower the spillover of global liquidity and the more the cushioning impact of domestic asset returns.”
So countries with fixed exchange rates should expect to have seen a significant impact on domestic asset valuations. And wouldn’t you know it! Just last week, fixed-exchange-rate China announced almost 12% growth in their economy last year and almost 12% growth in their housing market last month alone. That’s not to say that China doesn’t have huge growth potential, but you’ve really got to wonder.
So what are the implications of this Liquidity-Time Explosion, anyway? As the IMF paper explains, benefits aside, surges in capital flows can lead to large swings in the exchange rate (which can be de-stabilizing), or it can lead to a boom in domestic credit creation, possibly resulting in inflation, asset bubbles, and a general overheating of the economy.
Indeed, historically speaking, financial crises in emerging markets are usually preceded by a surge in capital inflows from abroad - often linked to factors identified in the previous paragraph. The recent work by Reinhart and Rogoff provided further evidence for that trend. The capital inflows are particularly de-stabilizing if they are short-term debt and denominated in a foreign currency.
Aware of all of this, the IMF paper explores the various policy options available for receiving countries, including an in-depth look at capital controls. Explore that if you wish. In macro-terms, I think it’s important to recognize that this situation exists and that it is a source of vulnerability. Remember that the capital is flowing out of the G4 due to low interest rates – if those rates go up, the capital inflows to emerging markets could slow down or even reverse. It is here that policy coordination in bodies like the G20 will prove to be crucial.
But even policy coordination cannot insure against the fact that Shit Happens – there are outlying events, black swans, fat tails of all kinds that can rapidly change the situation in any given economy. We have seen two examples of that recently with Iceland’s volcano and the tragic plane crash in Poland. This uncertainty about the future means that economies on the receiving end need to insulate themselves from potential shocks, while sending countries need to be aware of the knock-on effects of their policies. What seems clear, however, is that the status quo has potential for disaster.
