Emerging countries: victims or perpetrators?
The emerging world is experiencing another bout of financial instability, with some countries haemorrhaging foreign capital, dragging down markets and currencies. This global portfolio reallocation reflects a worldwide adjustment of the risk/reward trade-off following the rise in US interest rates, which has made dollar assets more attractive, while in the background, the amount of excess liquidity is set to decrease, calling for greater discrimination. At this stage, the crisis of confidence in emerging countries is not widespread: with fairly healthy fundamentals, more robust banking sectors, more flexible exchange rates and responsive monetary policies helping more easily absorb shocks, the majority of emerging economies are proving resilient, with capital outflows mainly targeting those countries considered financially fragile.
What the countries hit hardest by this loss of appetite – Turkey, Argentina, South Africa, India and Indonesia – have in common is that they all have large external deficits, increasingly funded by speculative capital searching for yield and/or high levels of hard currency debt sensitive to interest and exchange rate fluctuations. They have all – or almost all – pursued overly accommodative monetary policies and, over the past few years, experienced buoyant growth in private demand, financed by borrowing (sometimes in foreign currency), together with accelerating inflation, an excessive rise in asset prices and a tendency for their currencies to appreciate. These capital outflows are thus laying bare the fragile foundations of growth based on mounting financial imbalances against the backdrop of a sudden sharp increase in risk.
Emerging countries’ vulnerability to financial pendulum swings is nothing new. The countries concerned are undoubtedly guilty of not having learned all the necessary lessons from past crises, allowing financial imbalances to grow, with a correction bound to take place sooner or later. However, they are also victims of American monetary influence in a globalised world where capital can move about freely. The long period of low interest rates and plentiful liquidity following the Great Recession has distorted the allocation of global savings by influencing investor perceptions and tolerance in relation to risk. In its quest for returns, this financial manna has poured out indiscriminately. Faced with these hard-to-absorb capital inflows, recipient countries have found their monetary policies subordinated to those of the US Federal Reserve, with interest rates held too low relative to their position in the cycle so as to reduce the yield differential with the US and curb foreign investors’ risk appetite. Furthermore, these low interest rates have served as an open invitation to domestic players with access to international markets to take advantage of the situation by taking out new foreign currency borrowing at very favourable terms, thus placing themselves at the mercy of interest rate hikes or US dollar appreciation (notably for those operators whose income is mainly in local currency).
An initial warning sign came in 2013, when the Fed announced the end of its quantitative easing policy, triggering an upturn in volatility rather cutely referred to as a “taper tantrum”. Once the storm had passed, however, the search for yield resumed with renewed vigour until recently, when dollar appreciation and US rate hikes triggered this sometimes abrupt redirection of capital flows into safer and more lucrative dollar assets. Donald Trump’s procyclical fiscal policy also carries some of the blame for these latest cracks in the financial edifice due to the need to call on foreign savings to cheaply finance corporate tax giveaways and the US consumer lifestyle.
All of this raises questions over the globalised nature of monetary policy, and especially US monetary policy, with decisions dictated by purely domestic interests having an international impact, without any global regulating or coordinating mechanisms to limit the destabilising effects. To protect against the ups and downs of global finance, the idea of introducing targeted capital controls is gradually gaining ground, with the aim of dissuading purely speculative volatile flows in favour of longer-term investment to boost emerging countries’ productivity and help them catch up with the rest of the world. Even the IMF, long an apostle of financial liberalisation, is starting to believe in the stabilising benefits of targeted controls to regulate capital flows.
Group Chief Economist at Credit Agricole