A striking feature of the recent global
financial crisis and its aftermath is the behaviour of private international
capital flows, especially to emerging markets. Prior to the crisis, in
the years after 2003, a number of analysts had noted that the world was
witnessing a surge in capital flows to emerging markets. These flows,
relative to GDP, were comparable in magnitude to levels recorded in the
period immediately preceding the financial crisis in Southeast Asia in
1997. They were also focused on a few developing countries, which were
facing difficulties managing these flows so as to stabilise exchange rates
and retain control over monetary policy. They also included a significant
volume of debt-creating flows, besides other forms of portfolio flows.
Interestingly, these developments did not, as in 1997, lead up to widespread
financial and currency crisis originating in emerging markets, as happened
in 1997. However, the risks involved in attracting these kinds of flows
were reflected in the way the financial crisis of 2008 in the developed
countries affected emerging markets. Financial firms from the developed
world, incurring huge losses during the crisis in their countries of origin,
chose to book profits and exit from the emerging markets, in order to
cover losses and/or meet commitments at home. In the event, the crisis
led to a transition from a situation of large inflows to emerging markets
to one of large outflows, reducing reserves, adversely affecting currency
values and creating in some contexts a liquidity crunch.
Given the legacy of inflows and the consequent reserve accumulation, this,
however, was to be expected. What has been surprising is the speed with
which this scenario once again transformed itself, with developing countries
very quickly finding themselves the target of capital inflows of magnitudes
that are quickly approaching those observed during the capital surge.
As the IMF noted in the latest (April 2011) edition of its World Economic
Outlook: ''For many EMEs, net flows in the first three quarters of 2010
had already outstripped the averages reached during 2004–07,'' though
they were still below their pre-crisis highs.
One implication of the quick restoration of the capital inflow surge is
the fact that, in the medium-term, net capital inflows into developing
countries in general, and emerging markets in particular, has become much
more volatile. As Chart 1 shows, net capital flows which were small though
the 1980s, rose significantly during 1991-96, only to decline after the
1997 crisis to touch close to early-1990s levels by the end of the decade.
But the amplitude of these fluctuations in capital inflows was small when
compared with what has followed since, with the surge between 2002 and
2007 being substantially greater, the collapse in 2008 much sharper and
the recovery in 2010 much quicker and stronger.
When we examine the composition of flows we find that
volatility is substantial in two kinds of capital flows: ''private portfolio
flows'' and ''other private'' flows, with the latter including debt (Chart
2). There has been much less volatility in the case of direct investment
flows. However, in recent years the size of non-direct investment flows
has been substantial enough to provide much cause for concern. Further,
besides the fact that direct investment flows are differentially distributed
across countries (with China taking a large share), the definition of
direct investment is such that the figure includes a large chunk of portfolio
flows. The magnitude of the problem is, therefore, still large.
Does this increase in volatility during the decade of the 2000s speak
of changes in the factors driving and motivating capital flows to emerging
markets? The IMF in its World Economic Outlook does seem to think so,
though the argument is not formulated explicitly. In its analysis of long-term
trends in capital flows the IMF does link the volatility in flows to the
role of monetary conditions (and by implication monetary policy) in the
developed countries, especially the US, in influencing those flows.
As the WEO puts it, ''Historically, net flows to EMEs have tended to be
higher under low global interest rates, (and) low global risk aversion,''
though this assessment is tempered with references to the importance of
domestic factors. Shorn of jargon, there appears to be two arguments being
advanced here. The first is that capital flows to emerging markets are
largely influenced by factors from the supply-side, facilitated no doubt
by easy entry conditions into these economies resulting from financial
liberalisation. The second is that easy monetary policies in the developed
countries has encouraged and driven capital flows to developing countries.
This is because easy and larger access to liquidity encourages investment
abroad, while lower interest rates promote the ''carry-trade'', where
investors borrow in dollars to invest in emerging markets and earn higher
financial returns, based on the expectation that exchange rate changes
would not reduce or neutralise the differential in returns. Needless to
say, when monetary policy in the developed countries is tightened, the
differential falls and capital flows can slow down and even reverse themselves.
The evidence clearly supports such a view. The period
of the capital surge prior to 2007 was one where the Federal Reserve in
the US, for example, adopted an easy money policy, involving large infusion
of liquidity and low interest rates. While this was aimed at spurring
credit-financed domestic demand, especially for housing, so as to sustain
growth, it also encouraged financial firms to invest in lucrative markets
abroad. Flows reversed themselves when the losses and the uncertainty
resulting from the sub-prime crisis and its aftermath resulted in a credit
crunch. Finally, flows resumed and rose sharply when the US government
responded to the crisis with huge infusions of cheap liquidity into the
system, aimed at relaxing the liquidity crunch. A substantial part of
the so-called stimulus consisted of periodic resort to ''quantitative
easing'' or the loosening of monetary controls.
This close link between monetary policy in the developed countries and
capital flows to emerging markets is of particular significance because,
with the turn to fiscal conservatism, the monetary lever has become the
principal instrument for macroeconomic management. Since that lever can
be moved in either direction (monetary easing or stringency), net flows
can move either into or out of emerging markets. As a corollary, the consequence
of monetary policy being in ascendance is a high degree of volatility
and lowered persistence of capital inflows to these countries.
From the point of view of developing countries the implications are indeed
grave. When global conditions are favourable for an inflow of capital
to the developing countries, these countries experience a capital surge.
This creates problems for the simultaneous management of the exchange
rate and monetary policy in these countries, and leads to the costly accumulation
of excess of foreign exchange reserves. Costly because the return earned
from investing accumulated reserves is a fraction of that earned by investors
who bring this capital to the developing economy. Moreover, when global
conditions turn unfavourable for capital flows, capital flows out, reserves
are quickly depleted and there is much uncertainty in currency and financial
markets.
The problem is particularly acute for countries that are more integrated
with US financial markets, since dependence on the monetary level is far
greater in that country, partly because of the advantages derived from
the dollar being the world's reserve currency. The IMF's WEO, therefore,
predicts: ''economies with greater direct financial exposure to the United
States will experience greater additional declines in net flows because
of U.S. monetary tightening, compared with economies with lesser U.S.
financial exposure.'' This tallies with the evidence. Overall, ''event
studies demonstrate an inverted V-shaped pattern of net capital flows
to EMEs around events outside the policymakers' control, underscoring
the fickle nature of capital flows from the perspective of the recipient
economy.''
This increase in externally driven vulnerability explains the IMF's recent
rethink on the use of capital controls by developing countries. Having
strongly dissuaded countries from opting for such controls in the past,
the IMF now seems to have veered around to the view that they may not
be all bad. However, its endorsement of such measures has been grudging
and partial. In a report prepared in the run up to this year's spring
meetings of the Fund and the World Bank, the IMF makes a case for what
it terms capital flow management measures, but recommends them as a last
resort and as temporary measures, to be adopted only when a country has
accumulated sufficient reserves and experienced currency appreciation,
despite having experimented with interest rate policies. This may be too
little, too late. But, fortunately, many developing countries have gone
much further. Only a few like India, which is also the target of a capital
surge, seem still ideologically disinclined.