Innocent Bystanders

SANTIAGO – Take a taxi in São Paulo nowadays and you will experience the maddening traffic and untidy streets of an emerging-country metropolis. But when the time comes to pay for the ride, you may feel like you are in Boston, Luxemburg, or Zurich: the value of the Brazilian real, like the currencies of many emerging-market countries, is high – and could go higher.

Strong currencies make strong countries, a senior United States policymaker used to say. Many emerging-country exporters, struggling to retain customers in the wobbly US and European markets, feel otherwise.

For decades, developing countries dreamed of a nirvana of sky-high commodity prices and rock-bottom international interest rates. But perhaps finance ministers in Lima, Bogota, Pretoria, or Jakarta should have been more careful about what they wished for. The problem? An invasion of short-term capital flows fleeing the slow-growth, low-interest-rate advanced countries.

Meeting in Calgary last month, the Inter-American Development Bank reported that $266 billion entered Latin America’s seven largest economies in 2010, compared to less than $50 billion a year, on average, between 2000 and 2005. And while only 37% of inflows in 2006 were “hot money” that can leave at a moment’s notice, last year such inflows accounted for 69% of the total.

So, what is going on? Emerging countries in Latin America, East Asia, Eastern Europe, and Africa are innocent bystanders in the tussle between the US and China over currencies and trade imbalances. And the bystanders are absorbing some of the hardest blows.

For a decade now, the world economy has suffered from tremendous global imbalances: massive external surpluses in countries like China, Japan, Germany, Switzerland, and the oil producers, matched by equally large external deficits in the US, the United Kingdom, Spain, and others. The imbalances were reduced temporarily as the global financial crisis caused private demand to drop in the US, the UK, and elsewhere. But, starting in 2010, the imbalances returned, and, according to the International Monetary Fund’s recently released World Economic Outlook, they will not shrink between now and 2016. G-20 communiqués have repeatedly pledged to secure “adjustment” and “rebalancing” in the world economy, but those promises have come to nothing.

Still-troubled financial systems and huge fiscal deficits are keeping the West’s deficit countries (especially the US) from expanding domestic demand. And an unwillingness to trade away export-led growth is having the same effect on the East’s surplus countries (especially China). As a result, emerging countries, according to the IMF, have been pressed to carry “a disproportionate burden of demand rebalancing since the crisis.”

Countries running surpluses accumulate massive stocks of foreign assets, and those resources have to be invested somewhere. Before the crisis, a substantial amount of that money was invested in US, Spanish, or Irish real estate. Today, that market is dead and the money must go elsewhere. Europe, gripped by a tremendous banking and debt crisis, is not an attractive destination, and loose monetary policy in the US has produced ultra-low bond yields there. As a result, many emerging countries, with their higher interest rates and promising growth prospects, have become irresistibly attractive to investors.

After recent events in Tunisia, Egypt, and Libya, Wall Street analysts are waxing somewhat less optimistically about political stability in emerging countries. And a flat 2011 performance in some Latin American and Asian equity markets – following tremendous runs in 2010 – has taken a bit of sheen off the emerging-market investment fad. But the money keeps coming.

This dollar invasion is making macroeconomic management in emerging countries even more challenging than usual. If high commodity prices are expected to persist, then some strengthening of currencies is both desirable and inevitable. But a thin line separates orderly adjustment to changed conditions from market over-reaction. And sensible people in many emerging-country capitals are wondering whether we have crossed that line.

Loss of export competitiveness as a result of excessively strong currencies is not the only problem. Massive capital inflows caused real-estate and stock-market bubbles in the US and parts of Europe. Today, some policymakers in Latin America, worried that the same thing could happen to their countries, are casting about for policy tools to prevent it.

As a result, the US Federal Reserve’s policy of so-called “quantitative easing” is going south, where it takes the form of foreign-exchange intervention. If rich-country central banks can buy long term bonds, then emerging-country central banks can buy dollar-denominated bonds. Even countries that practice inflation targeting and have otherwise vowed to let their exchange rates float – Brazil, Colombia, Peru, and Chile, for example – have done it, and in large quantities.

Expect macroprudential policies to go south, too – and to be redefined in the process. If buying dollars is not sufficient to stem the appreciation tide, regulators in emerging economies will erect an array of other barriers to keep money out.

None of these policies is without costs. They are second-best local-policy responses to an ineffective mechanism for international adjustment (or non-adjustment). A better system to rebalance the world economy is as necessary as it is unlikely. All we can look forward to is the next G-20 communiqué.
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Andrés Velasco, Chile’s finance minister (2006-2010), teaches Public Policy at the Kennedy School of Government, Harvard University.

Copyright: Project Syndicate, 2011.
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