Friday, January 31, 2014

The lessons from the travails of "Fragile Five"

Fragile Five is the new club in town. The central banks of BrazilIndiaTurkey, and South Africa have hiked interest rates, some dramatically, either to backstop falling currencies (Turkey and South Africa) or stem rising inflation (India and Brazil). While all of them suffer from weak economic fundamentals (triple whammy of high inflation, fiscal deficit, and current account deficit) and political uncertainty (elections looming this year), a sudden reversal of cross-border capital flows has amplified the problems and triggered off a potential crisis in many developing economies.

International investors, spooked by the Fed's decision early this week to taper its bond-buying program and uncertainty about China's slowing economy, have responded by fleeing equity and bonds markets of emerging economies. They perceive the former as reflective of normalcy returning to the US, with the resultant prospect of higher interest rates in the US, and the later as likely to sharply reduce global demand especially for commodities, thereby adversely impacting many emerging economies. A spiral of self-reinforcing market expectations and resultant contagion have been hammering the emerging economies.

Now, this is a teachable moment about the risks that are likely to arise from the financialization of an integrated world economy and how nation states can prepare to mitigate them. Consider these existential realities.

Political uncertainty and the electoral business cycles are part of the game in democracies and autocracies alike. Institutional weakness and regulatory failures will remain a feature of many of these economies for the foreseeable future. Economic mis-management is not likely to disappear as long as humans run national governments. Similarly, countries, both developing and developed, are always as likely to run deficits, domestic and external, as surpluses.

In the present crisis, notwithstanding the undoubted problems of economic mismanagement and political uncertainty in many economies, the sharp gyrations of global capital flows have exacerbated the problems facing many developing economies. In fact, they have amplified individual national macroeconomic problems and moved them into a potentially global, or atleast emerging markets-wide, economic crisis. This is only the latest example of recurrent sudden-stop induced crises that have become a feature of the global economy in recent decades. Surely, the conditions are not as dire enough to merit this level of divergence in currency valuations,
An economic boom or uncertainty in developed economies drives capital into an emerging economy. It inflates asset market bubbles and distorts incentives that lead to resource mis-allocation in that country. Economic mis-management and other negative accompaniments are never far-away. Investors then realize all these problems and then a sudden-stop ensues, followed immediately by sharp reversal of capital flows. This time is no different.

It is painfully obvious that nation states need to pursue a macroeconomic policy framework that gives them the best change of both preventing such sudden-stop induced crises as well as dealing with them if need arises. A carefully calibrated approach to allowing external capital flows, especially in good times, has to be a central feature of this framework. The IMF has wisely reconsidered its views on managing capital flows advising caution on capital account liberalization.

In the circumstances India needs to be cautious about managing its capital flows liberalization policy. Instead of pursuing any desirable single goal post of "capital flows liberalization", we should adopt a policy of carefully calibrated policy of "capital flows management" with multiple-goals, all aimed at ensuring external macroeconomic stability.

Update 1 (1/2/2014)

Floyd Norris,
Capital controls can make sense when times are good. Countries that have easy access to loans may be better off not taking them.

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