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Wednesday, April 1, 2015
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- As in previous episodes, a key factor in the current boom in capital flows to developing and emerging economies (DEEs) is a sharp cut in interest rates and a rapid expansion of liquidity in the major advanced economies (AEs), notably the US. This first occurred in a coordinated way after an agreement at the April 2009 G20 summit in London as a countercyclical response to the crisis. In the US, recovery started in summer 2009 but the strong growth of nearly 4 percent in the first quarter of 2010 slowed to less than 2 percent in the second quarter. The response of the US Federal Reserve was to initiate another round of quantitative easing through purchases of long-term treasuries and other securities. Although the declared objective was to stimulate private spending by lowering long-term interest rates and raising asset values, this move has also been widely seen as an effort to weaken the dollar and stimulate exports.
But the rapid expansion of liquidity has not translated into a significant increase in private lending and spending in the US because of problems on both the supply and demand sides of the credit market. As uncertainty about recovery and stability has continued unabated, banks have not been willing to lend to the private sector but have simply cashed in on the differentials between short- and long-term rates and looked for profit opportunities abroad.
Similarly, consumers, overburdened with debt, have not been keen on borrowing and spending while, in the face of relatively stagnant consumer markets, firms have not had much incentive to continue the investing and stock-piling that they had started earlier. As a result, excess liquidity has spilled over globally in a search of yields in DEEs, many of which have been put on the defensive in response to what is widely seen as a competitive devaluation by the US.
A key factor in the surge in capital inflows to DEEs after the Lehman bankruptcy in September 2008 was their significantly higher growth performance and prospects than the AEs. Yet although interest rates in many major DEEs were initially brought down in response to fallout from the crisis, the arbitrage gap widened as they began to raise them in 2010, while rates in AEs remained at very low levels. As a result, carry-trade has been re-established and key emerging economies with high interest rates such as India and Brazil have become the main targets. Low interest rates in the US, together with the ongoing weakness of the dollar, made the dollar the new funding currency for carry-trade operations.
Furthermore, because of unprecedented difficulties encountered by large financial institutions in the US and Europe and increased public deficits and debt, the crisis has given rise to a lasting shift in investment to the DEEs from AEs, where risk is perceived as being greater. A natural outcome is that DEEs now constitute a larger portion in the equity and bond portfolios of investors in AEs.
This is largely because these markets have rapidly become more like financial markets, with several commodities being treated as a distinct asset class and attracting growing amounts of money in search of profits from price movements.
The parallel movements in capital flows, commodity prices, and the dollar are not due only to the overall market assessment of risks and return and global liquidity conditions; they are also directly linked to each other. A weaker dollar often leads to higher commodity prices because it raises global demand by lowering non-dollar prices of commodities. On the other hand, changes in commodity prices have a strong influence on capital inflows to commodity-rich DEEs.
These changes have important consequences for the vulnerability of DEEs to boom-bust cycles. Exposure to the risk of instability and crises generally results from macroeconomic imbalances and financial fragility that accumulated during the surge in capital inflows, mainly in three areas. First, surges in capital flows can produce or support unsustainable exchange rates and current account deficits. This is quite independent of the composition of capital flows. A surge in Foreign Direct Investment (FDI) would have the same effect on the exchange rate, exports, and imports as a surge in portfolio investment or external borrowing. If such imbalances are allowed to develop, sudden stops and reversals would produce sharp declines in the currency and economic contraction unless there are adequate reserves or unlimited access to international liquidity.
Second, financial fragility arises because of the extensive dollarisation of liabilities and currency and maturity mismatches on balance sheets. This would be the case when borrowing is in foreign currency and short-term. When capital flows dry up and the currency declines sharply, mismatches could result in increased debt servicing difficulties and defaults.
Finally, capital surges can produce credit and asset bubbles. Credit expansion can occur when banks borrow abroad to fund domestic lending, currency market interventions cannot be fully sterilised, or inflows lower long-term interest rates. The linkage between capital flows and asset markets strengthens with the greater presence of foreigners in domestic markets. Not only portfolio investments but also many types of capital inflows that are traditionally included in FDI, such as acquisition of existing firms and real estate investment, can create asset bubbles. Reversal of capital flows could then create credit crunch and asset deflation with severe macroeconomic consequences. (END/COPYRIGHT IPS)
(*) Ylmaz Akyuz is the Chief Economist of the South Centre. For further analysis see South Centre Research Paper 37 ( http://www.southcentre.org)