Emerging markets are right to worry about capital flows

The author is the former President of the Reserve Bank of India

One Inflation rate In the 12 months to May, the interest rate in the United States was 5%, well above the Fed’s target rate of 2%. This has sparked speculation that the Fed may soon begin to reduce pandemic-driven interest rates. Currency support.

Eight years ago, when the then chairman Bernanke publicly hinted that the Fed might begin to “shrink” its quantitative easing program, global markets fell into chaos. Yields have soared, risk assets have plummeted, and currencies of emerging economies have plummeted. Are we going now”Taper Tantrum 2.0“?

Hit by past experience, the Fed tried to ease concerns about unexpected policy reversals. Chairman Jay Powell has been trying to emphasize that he will remain patient and will not relax the Fed’s balance sheet without seeing “substantial further progress” in the recovery. Several Fed officials responded to these assurances, saying that the Fed will not react hastily to the short-term spike in inflation.

Even so, emerging markets are right to be concerned about possible domestic market turmoil. After all, due to the exceptionally loose money supply and low returns in rich countries, emerging markets inevitably become the preferred destination for investors seeking high returns. When the cycle turns, capital flows suddenly reversed, throwing the asset and currency markets of emerging countries into turmoil.

India is one of the “Five Vulnerable Countries” in the summer of 2013. It is a typical example of emerging markets susceptible to fluctuations in capital flows. The country has a huge current account deficit every year, and the source of these deficits is the loose money released into the global system by quantitative easing implemented by rich countries.

We are complacent and under pressure. When the inevitable implosion appears as the first signal of policy normalization, it turns out to be hugely destructive. In just three months, the rupee fell by more than 15% from peak to trough, causing huge losses to economic growth and welfare.

Since then, India has established a huge reserve fund, which is generally regarded as the first line of defense against turbulent capital flows. But the frustrating thing is that this does not prevent a volatile market.

Consider the policy dilemma of the Reserve Bank of India during the current crisis. Despite the pandemic and related blockades, India’s stock market is still booming, thanks to the massive liquidity that the Reserve Bank of India has injected into the system as part of its crisis management. As a result, foreign capital poured in.

The Reserve Bank of India has been in the market almost all the time, buying US dollars to prevent unwarranted appreciation of the rupee. But buying U.S. dollars will result in additional rupee liquidity, which may exceed the comfort of the central bank. The Reserve Bank of India can certainly absorb additional liquidity by selling bonds. But such a move would cause interest rates to soar, causing the economy to be flooded with “arbitrage trading” dollars, which hope to make money from the difference in yields.

The Reserve Bank of India faces a dilemma. Intervene in the foreign exchange market, but will not offset the resulting liquidity (by not selling bonds), and more foreign capital will be attracted by the returns from the stock market. Intervene but offset the flow, and more capital will still enter, attracted by the potential difference in yields. In either case, when loose money reverses, the economy must pay the price of adjustment.

This shows that foreign exchange reserves are at best a defensive weapon to manage the fluctuations caused by the reversal of capital flows. They do not help prevent pressure buildup in the first place.

If foreign exchange reserves are not sufficient defense, are capital controls the answer? We know that it is almost impossible to design capital controls that allow the right type of capital to enter and exit at the right time and in the right amount.

In order to minimize the cost of financial globalization and maximize its benefits, emerging markets must maintain huge reserves and maintain the sustainability of fiscal and current account balance. They must minimize short-term foreign currency debt, especially sovereign debt, and implement capital controls wisely and credibly.

India’s experience shows that even with all these measures, these countries still have to deal with the so-called impossible trinity, that is, no economy can have a fixed exchange rate, an open capital account, and an independent monetary policy at the same time.

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