Global Trends by Martin Khor

Monday 21 March 2011

Dangers of the boom in capital flows

The present boom in capital flows to developing countries is having destabilising effects on currencies and asset bubbles and it will also end in a damaging bust, warns a new South Centre paper. 

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Huge funds at near-zero interest made available by the United States and other developed countries to boost their flagging economies are instead fuelling booms in capital flows to developing countries and in commodity prices.

Both booms are already having destabilising effects on many developing countries. And they will also end in a bust, as has happened with previous booms, and this will have an even more damaging impact. 

Therefore international regulation as well as national policy measures are urgently needed to control this boom-bust cycle.

These are the key conclusions of a new South Centre research paper, “Capital Flows to Developing Countries in a Historical Perspective:  Will the Current Boom End in a Bust?”

It is authored by the Centre's Chief Economist Dr. Yilmaz Akyuz, who made a presentation on its key points at a launching ceremony at the United Nations in Geneva last week.  Dr. Supachai Panitchpakdai, UNCTAD Secretary-General also made extensive comments on the paper at the meeting, attended by diplomats and UN staff.

Akyuz said that as part of the policy intervention applied by advanced economies, the US in particular, large amounts of liquidity have been made available at near-zero interest by the governments or Central Banks.  The current US$600 billion “quantitative easing” by the US Federal Reserve is an important example.

However, these monetary expansion measures have been unable to establish stable and vigorous growth in the advanced economies.  Instead the funds have been channelled mainly as speculative capital flows in search of higher yield to emerging economies and to the commodity markets. 

This is transmitting destabilising impulses to developing countries through their impact on exchange rates and on the markets for assets, credit and commodities, threatening their growth and stability.

Moreover the capital flows are likely to be reversed, with significant damage to the developing countries.  Thus the effective management of these capital flows is essential for developing countries to survive the global economic turmoil.

The paper traces the post-war boom-bust cycles in capital flows, pointing out the first cycle starting in the late 1970s, ending with the debt crisis in the 1980s in Latin America; the second boom starting in the early 1990s, ending with the East Asian crisis; and the third boom starting in the early 2000s that ended with the Lehman Brothers collapse in September. 2008. 

However this last bust was short-lived and a fourth boom started in the second half of 2009 and is now continuing with full force.

Although these cycles differ in nature and destination, they also share some common features.  The booms are characterised by rapid liquidity expansion and low interest rates in the main reserve issuing countries, especially the US.  The busts are catalysed by tighter credit conditions, rising dollar interest rates and a strengthening of the dollar; and in recipient countries, there is a deterioration in macroeconomic conditions, mostly due to the effects of the capital inflows themselves.

In the current boom, starting in mid-2009, the quantitative easing (pumping of government funds into the banking system) in the US and Europe were not mainly translated into domestic credit expansion but instead spilled over to the developing countries through investors seeking higher yield. .  This is because of developing countries have higher interest rates, thus encouraging the “carry trade” (borrowing in a currency with low interest and investing in a currency with higher interest); a shift in risk perception against advanced economies, and better growth prospects in developing countries.

There have been three adverse effects of the surge of capital inflows into developing countries: 

l        Their exchange rates have appreciated significantly, thus making their exports less competitive and affecting their balance of payments.  Ironically those countries with current-account deficits like India, Brazil, South Africa, Turkey have had the sharpest currency appreciation; 

l        There is a build up in short-term private debt in some countries, which increases corporate default if the currency appreciation is reversed; and

l        The creation of asset bubbles, with equity prices rising in tandem with capital flows.  There is the risk of a hard landing when flows are reversed.

The paper also shows that there is a cycle in commodity prices which is associated with capital flows. This commodity cycle is similarly influenced by the liquidity provided by advanced economies and the investors' search for higher yield.

The paper points to the financialisation of commodity markets, with investment in index trading rising from US$13 billion to $320 billion (between 2003 and 2010).   The paper shows a close correlation between the fluctuations in private capital flows and in commodity prices, and an inverse relation between the value of the dollar and commodity prices.

Looking at the historical record of previous cycles, the paper predicts that both the booms in capital flows and commodities will end with a bust.  This could happen through one of three scenarios: an abrupt monetary tightening in the US; monetary tightening and slower growth in China; and a balance-of-payments or financial crisis in a major emerging economy.  

The paper examines three policy options for developing countries in managing surges in capital flows:  currency market intervention and “sterilisation”; liberalising and encouraging capital outflows by residents; and capital controls.

Pointing to the limitations and drawbacks of the first two options, the paper elaborates on the need for capital controls.  Measures taken by some countries have not worked because they have been inadequate; for example, low taxes on capital inflows are not enough to discourage them when interest differentials are large and the currency is appreciating.

There is thus the need for direct restrictions over private borrowing from abroad and on the entry of non-residents into domestic securities markets.

The paper concludes that capital controls can be sufficiently effective to make a difference, if done vigorously.  There is need for determined action by developing countries to control capital flows, both inward and outward.   They should not allow their currency and current account situations to get out of hand.

Meanwhile, there is also need for reform of the international financial architecture to reduce systemic instability.  The reforms include regulation of international capital flows (including in the source countries), regulation of trading in commodity futures, and reforms in the currency reserves system and the exchange rate system.

Note:  The paper is available on the South Centre website, www.southcentre.org