Conventional wisdom has been that capital flows are a blessing to emerging economies, bringing needed funds to countries where investments are most productive. But if history is any guide, capital flows have proven to be highly volatile--surging in good times and collapsing in gloomy ones.
The global financial crisis has renewed the debate over the desirability of capital flows to emerging economies. Adding fuel to this debate is the fact that two of the world's largest emerging economies--China and India--have experienced strong growth and relatively limited fallout from the crisis, all the while maintaining hefty restrictions on the flow of foreign capital.
What can be done to ensure that emerging economies still benefit from productive foreign capital, while reducing the risks associated with highly volatile flows? Can we throw out the bathwater, but keep the baby?
The case of emerging Europe
In emerging Europe, the transition from planned economies to capitalism has resulted in a rapid and near-complete openness to trade and foreign capital. In the years before the crisis, foreign money flowed generously to the region and to banks in particular.
This precipitated a credit boom--with banks extending loans to households and firms on an unprecedented scale. Once the crisis hit, the boom turned to bust. And although the withdrawal of foreign capital was less aggressive than initially feared, it is clear that the large pre-crisis capital flows to the region were unsustainable and destabilizing.
Macroeconomic policy options
So, what are the options for dealing with large capital flows? The tradeoffs arising from macroeconomic policies are well known:
● Exchange rate appreciation. Allowing the exchange rate to appreciate can lead to overvaluation and is not an option for countries with exchange rate pegs. To reduce pressures on the exchange rate, interest rates can be cut, provided that inflation is not a concern.
● Reserve accumulation. Accumulating international reserves can be effective for a while if reserves are deemed to be too low. However, if purchases of foreign currency are unsterilized--if they increase domestic liquidity--inflation may become a problem. And sterilized intervention can become self-defeating, as rising interest rates create a more attractive destination for foreign capital.
● Fiscal policy. Fiscal policy can be tightened, but there are limits (both political and economic). And strong fiscal or external positions can end up attracting even more inflows. Just look at Russia--as reserves increased by some $500 billion in the pre-crisis years, investors lent the private sector roughly the same amount.
An expanded toolkit
Since macroeconomic policies may not be enough to deal with massive inflows of foreign capital, the toolkit has to include other instruments. Strengthening the prudential framework can help mitigate the adverse consequences of surging capital inflows, but other options--notably controls on capital inflows--may also need to be considered.
In emerging Europe, stronger prudential regulations could have gone a long way to reducing the credit boom fueled by foreign capital.
● Limiting foreign currency lending. Many of the loans to emerging European households in the boom years were denominated in foreign currency (such as Swiss francs), even though these households only had income in domestic currency. This type of "currency mismatch" created significant risks not only to households--who faced very large increases in their loan payments when their currency depreciated--but also to banks--because when households could no longer afford their loans, they defaulted. Thus, one possible prudential measure would be to limit (or potentially ban) foreign currency lending to borrowers without foreign currency income.
● "Countercyclical regulatory requirements." Put simply, these require banks to hold extra capital in good times that would serve as a buffer in bad times. Operationally, these requirements mean that banks would have fewer funds to lend out in good times, which would help to dampen a credit boom. Countries that took such measures in the run-up to the crisis had mixed success, but this might mean that a more aggressive effort may be needed going forward.
But what if foreign capital is not just flowing into banks? And what if it is, in fact, an unintended consequence of policies in other countries? In many countries in emerging Europe, companies besides banks borrowed directly from foreign investors. And some of the foreign funds that the region attracted came from investors in search for yield, given low interest rates in advanced economies. In such situations, capital controls could provide a useful remedy.
● Capital controls to reduce investors' returns. Such capital controls can be in the form of a direct tax (such as the ones recently introduced in Brazil and Taiwan) or an indirect tax (such as requirements that investors place a portion of the invested funds in non-interest bearing accounts).
● Temporary in nature? But capital controls are not a panacea--they can be difficult to administer, they can be circumvented, and their effectiveness appears to decrease over time.
This means that controls need to be part of a broad package of policies to deal with large capital flows. It also means that they may be most effective as a temporary response to adverse spillovers or distortions in the global financial system that are also likely to be temporary.
What next for the new member states
Finally, let us not forget that the challenges facing the new member states, which are constrained in their ability to impose capital controls by the rules of the European Union. For some of these countries, greater use of prudential regulations--following Poland's example--could be a first step. And given the broader debate underway on financial transactions taxes in international fora, such as the G-20 group of advanced and emerging economies, the new member states should consider whether this form of regulation would be appropriate for their economies and take part in the discussion.
The bottom line
In our highly globalized economy, large and rapid flows of money across borders are here to stay. The challenge for emerging economies is to find ways to manage these flows so that they don't exacerbate boom-bust cycles, while still leaving the door open to productive (and hopefully stable) investment. This means using all available tools, particularly greater use of prudential regulations, and keeping an open mind when it comes to capital controls.
From the iMFdirect blog.
It is not that the system lets publically traded companies chose between taking an ant or grasshopper approach, it actually makes being an ant who considers the coming winter, a fireable or sueable offence.
Regulations appear to be one of the possible ways of protecting emerging economies from the volatile waves of the global financial market.
However, in business dealing, people make imprudent decisions not under the gun, but lured by high profits. A few make big money fast, but everybody else needs to learn how to eat with a teaspoon but everyday. In-deep information about risks of global financial markets needs to be provided to new players in the emerging markets. Some countries might not be able to afford to learn by mistakes.
Lastly, on the longer run, it counts where capital stays. If conducting business in one country is easier and cheaper than somewhere else is, even in tough times capital will not go away as badly as from other places. Nothing can replace good pro business policy.
This is like the CEO of Goldman Sachs telling us what we need for banking reform.
The world is depending on the United States to confront the international monetary financier power, lead and cooperate with other nations in reorganizing the world economic / financial system, under Glass-Steagal standards. Rational, courageous, and powerful measures must counterattack the collapsing operation of the monetary system.
for more info; www.larouchepac.com
Among those people, however, and especially in high places, are "criminals."
All of the people formed "nations" and wrote "laws," to guard themselves against those criminals.
But, words like "multi-national" and even "internatinal" have been taken as: "Lawless."
And -that- my good sir is why the present system fails. (And why the legislators at every step are all too willing to help it be so.)
Human nature.
"Laws" of each country must apply nonetheless. You cannot sweep them all away. We cannot operate without our national identities and heritage. We must assimilate both ideas without annulling either.
It was pointed out to me once that the only way caplital flows is as money. You seem to confuse money which can be an extionsion of credit with capital. Why confuse this issue?
The carry trade is an ugly abuse of different interest rates around the world that rests with borrowed money to "steal" claims on assets that have been earned by working people. While there may be some capital (down payment in cash) for borrowing, the entire disgusting mess is the province of improvidence committed by bankers with borrowed funny money. And the boys in charge (you must know who they are) are either asleep, ignoranmus', or they're in on the take.
The public really does expcet better.