Chilean Macroeconomic and Financial Outlook: The Emerging Markets Policy Response to the Tsunami of Capital Flows

The tsunami of capital inflows affecting emerging market economies these days is an important challenge for their macroeconomic stability. The surge is generating real currency appreciation, overheating and inflationary pressures, and, in some cases, a widening current account deficit. The depth and duration of the external financing shock is putting macroeconomic stability at risk and endangering the survival and competitiveness of non commodity traded goods sectors, particularly in agriculture and manufacturing.  

Confronting the surge with a fixed exchange rate system seems to be an inferior alternative. Those emerging market countries that follow this route will face higher and more persistent capital inflows, money creation and stronger inflationary pressures that will also result in real currency appreciation, and, most likely, will also have to face bubbles in domestic asset prices. Confronting the surge with massive and unsterilized currency intervention is equivalent to maintaining a fixed exchange rate, and in my opinion should be avoided.  

The emerging market countries that confront the surge with a floating exchange rate regime may have some advantages, however they are also very much affected by the financial shock.  Letting the currency to freely float would reduce the pressure of capital inflows and avoid inflation and overheating, but at the cost of maximizing the impact of the surge on the real exchange rate. The currency will appreciate so as to increase the value in dollars of domestic assets up to the point that the market satisfies its demand for emerging market exposure. It would be easy to just float to the extent that economic agents are prepared for exchange rate volatility. However, we know from past experiences that in emerging market countries the exposure to exchange rate risk continues to be high in the real sector, particularly in small and medium size firms that produce traded goods. They either have limited access to hedging instruments or are unwilling to implement hedging strategies due to costs or agency type problems.

The free float response may be complemented with measures directed at mitigating the effects of the loss of competitiveness through cost reductions or productivity gains in the production of tradable goods. Another possibility is to implement subsidies for the use of labor or energy in the most affected traded goods sectors, which may conflict with international treaties and trade agreements, and may require raising taxes to sectors benefited from high international prices or from the currency appreciation. These mitigating policies may help, but their effectiveness seem to be very marginal given the magnitude of the loss of competitiveness that may end up affecting non-commodity exports and import substitution under free floating.

Can we do better in avoiding the effects of the capital flow tsunami than just letting the currency float freely and using palliatives against excessive real appreciation?  Emerging market economies have two other possible strategies: sterilized intervention and capital controls, both with limited effectiveness and associated risks.

Sterilized intervention involves the purchase of international reserves by the Central Bank or the Treasury, financing it by issuing debt in domestic currency, nominal or indexed to inflation. Its effectiveness will depend on the responsiveness of international capital flows to the differential between domestic and foreign interest rates, or the degree of international capital mobility. If the mobility is very high and domestic emerging market debt is seen as a perfect substitute to international debt, there is no amount of intervention that would succeed in reducing the exchange rate appreciation demanded by the market.  Sterilized intervention is costly because the returns on reserves are lower than the financing cost in emerging markets debt, and several emerging market countries have already accumulated huge net foreign asset positions so that more intervention would imply increasing risks and costs.

While sterilized intervention may help to confront the tsunami, considering that most likely capital mobility is not perfect, it should be carried out under the commitment of following in the future a symmetrical policy.  The monetary authorities of emerging markets buy reserves when the real exchange rate exceeds a certain deviation from its estimated long run equilibrium (excessive real appreciation) and sell reserves when the currency is overly depreciated above a certain degree. The very strong traded goods lobby in emerging markets may limit the symmetrical response, but without it the possibility of a succeeding in limiting excessive real appreciation with intervention are very much reduced: the market knows that a Central Bank with a large over exposure to foreign exchange will not be able to continue intervening much longer. 

Another policy with effects equivalent to sterilized interventions is related to modifying the limits to foreign currency investment by local financial institutions (banks, pension funds, and insurance companies), inducing or even forcing them to take net positions in U.S. dollars. This action amounts to a sterilized currency intervention done using the financial system, with the caveat that it may weaken the futures system’s solvency as it takes net exposure to foreign exchange risk. This type of intervention can dress like the “creation of incentives for capital out flows”, but to the extent that the financial system is reluctant to take excessive exposure to foreign exchange risk, or is not forced to do so, this type of policy actions are quite ineffective to confront the capital flows surge.

Capital controls are the remaining alternative for emerging market economies. They are despised by most orthodox economists and even have been actively prosecuted by the US government by forcing the prohibition of capital controls through its international trade agreements. Although the current US administration has a different prospective, the limitations to the use of capital controls are still in the treaties. The controls used to address massive capital inflows include reserve requirements on inflows, as those used in Chile and Colombia in the 90’s, or taxes on holdings of domestic assets by foreigners such as those used now in Brazil. The idea of this type of controls is to increase the relevant foreign financing costs, so as to modify the arbitrage conditions, allowing that at the same domestic interest rates capital inflows are lower and the exchange rate is more depreciated.  The effectiveness of these controls has shown to be limited, particularly to the extent that the tax or the reserve requirement is focused on the “bad type” of capital inflows only, namely short term inflows.  However, if the scope of the controls is wider, and they cover capital inflows in general, and “loopholes” are actively closed by a diligent task force, then its effects would be much higher than in past experiences.

Most emerging markets are far from implementing wide raging capital controls for ideological, diplomatic, practical and political reasons. Ideological reasons are the reluctance of some authorities to even consider this type of mechanism, which has been repeatedly manifested in writings and speeches. The diplomatic reasons are associated to the trade agreement with the U.S., which prohibits restrictions to the capital account.  The practical reasons are that countries do not have technical teams and systems for monitoring compliance to capital account regulations. Finally, the political reasons against implementing wide ranging capital controls are that emerging market authorities are not ready to tax all forms of capital inflows. Those that are consider superior flows, direct investment or long term suppliers credit, are protected by very strong lobbies that would not allow any taxation on such important tools for development.

Unfortunately emerging markets seem to be stuck with inferior responses to the external financing shock: just some sterilized intervention that may limit somewhat the appreciation; or at most for those non-ideologically challenged, narrowly focused controls on capital inflows. We better pray for the financing shock to be short-lived and may the US Fed be listening.