Volatile international capital flows in emerging economies
Volatile capital flows have maintained, if not exacerbated, the vulnerability of developing and emerging countries and affected domestic productivity and employment.
Developing and emerging countries have a long history of vulnerability to large and volatile short-term capital flows. The last decade has seen a new wave of such flows of unprecedented size and fickleness. Private financial flows, such as portfolio flows, banking lending and foreign direct investment (FDI), surged from an average of US$487 billion in 2003-2005 to more than US$1,500 in 2007 to contract to less than US$500 billion again in 2009. Moreover, the nature of these capital flows has changed. Rather than foreign currency denominated assets, foreign investors, such as international banks and funds, have become increasingly exposed to short-term domestic currency assets. These include domestic currency bonds, equities and alternative asset classes such as derivatives and indeed the currency itself, as in the notorious carry trade phenomenon. In that case, investors borrow in low interest rate currencies like the Japanese Yen to invest in high interest rate currencies like the Brazilian Real, South African Rand or Turkish Lira. As a result, foreign investors have been able to profit from both domestic financial returns and exchange rate movements.
According to mainstream authors and international organizations like the International Monetary Fund (IMF), these changes should reduce the vulnerability of developing and emerging countries to volatile capital flows, as the countries are able to borrow in their own currencies. In a forthcoming paper with Juan Pablo Painceira we argue that this has not been the case. On the contrary, we show that these structural changes have maintained, if not exacerbated, the external vulnerability of developing and emerging countries, for several reasons.
First, foreign investments in domestic currency assets, funded on international financial markets, create a currency mismatch for foreign investors. This makes them very sensitive to or unexpected exchange rate changes, increasing the volatility of their investment decisions. This volatility is exacerbated by an increasing share of assets aimed at generating returns from capital gains, which can be easily wiped out when domestic or international market conditions change. Finally, as mentioned above, in the case of domestic currency assets, the exchange rate becomes a crucial element of international returns. This importance, in turn, creates the risk of destabilizing feedback and bubble dynamics, if expected or unexpected exchange rate gains are validated by large capital flows in thin financial markets. Returns from capital gains, which can be easily wiped out when market conditions change, contribute to the volatility of these capital flows.
The consequences of these volatile capital flows have been sustained appreciations of domestic exchange rates, interrupted by sudden and sharp depreciations as investors reverted to international financial markets. These adverse exchange rate movements, in turn, had devastating consequences for industrial production and employment. Whereas sustained appreciations created problems of competitiveness for domestic exporters, large and sudden exchange rate movement weighed on domestic producers’ ability to form long-term expectations, which, according to Keynes, are crucial for the investment process. Moreover, whereas the industrial sector suffered, the financial sector reaped substantial gains from volatile asset prices, worsening income distribution.
The dangers of volatile capital flows and excessive exchange rate movements have not remained unacknowledged by international organizations such as the IMF. Indeed, in an apparent U-turn, the IMF has recently endorsed some form of national capital account regulations. These measures should be temporary, levied primarily on inflows rather than also on outflows, and follow a clear, unified path across all developing and emerging countries.
Although an important step, we argue that these measures do not go far enough. Rather than temporary, national capital account regulations should be imposed as a permanent measure to shield developing and emerging countries from the vagaries of international financial markets. These measures, imposed by the governments of these countries, should also include controls on supposedly long-term capital flows, such as FDI, which can be short-term portfolio flows in disguise. Identifying these and the risks created by foreign investments require a detailed microstructural analysis of specific financial markets of these countries.
In particular, our paper suggests identifying the specific locus of exchange rate determination to avoid the adverse exchange rate dynamics discussed above, and regulations that require foreign and domestic investors to fund themselves on domestic financial markets to avoid destabilizing currency mismatches in their balance sheets. These measures, we argue, should reduce the vulnerability of developing and emerging countries to volatile capital flows and help foster a domestic accumulation process which draws on domestic rather than international savings. This process has to be accompanied by targeted industrial policy to create a well-diversified and productive economy which generates decent employment for everyone.