Of Currency Wars and Capital Controls

As a student of South-South cooperation--no matter how its ambitious goals are often negligible or even contradictory in practice--international bodies promoting such cooperation are of interest to me. One of these happens to be the South Centre, which sends me newsletters every so often either because I subscribed sometime ago or they discovered my research interests in third world issues. It describes itself as an "intergovernmental policy think tank of developing countries" and its HQ is in, er, Geneva. I'd like to think of the location as a manifestation of many important international organizations being based there such as various UN bodies and the WTO. My home country being one of the many LDCs funding this think tank (including China and the DPRK), I have naturally made use of its output once in a while, though it's not always that I agree with its stances.

However, Yilmaz Akyuz recently had a contribution that caught my eye on the quasi-eternal topic of international capital flows. There are, of course, two versions of this story. The first is the one we often hear from the likes of Martin Wolf and other apologists for subprime globalization that goes like something like this:

• LDCs should welcome capital flows since they are more attractive investment destinations with more future growth opportunities than developed ones;
  
• However, LDCs keen on maintaining export competitiveness are wary of local currency appreciation that such inflows bring;
• Hence, capital controls imposed by developing countries to limit inflows unnaturally distort the global economy and promote economic imbalances
  

On the other hand, you have the Guido Mantega [1, 2] "international currency war" version:

• Excessively loose fiscal and monetary policies in developed countries have caused hardships for developing ones by in effect exporting inflation as manifested by heightened prices for food, energy and commodities in the Global South;
  
• Meanwhile, exchange rate policies of benign neglect encourage beggar-thy-neighbour competitive devaluations against LDCs;
• By using capital controls, therefore, LDCs are merely trying to protect themselves from destabilizing policies emanating from developed countries

This coming from the South Centre, you should not be surprised that the second version is what's being promoted here. The major thesis is that large capital inflows tend to precede economic crises felt in the developing world such as the Latin American debt crisis and the Asian contagion. We are said to be on the verge of another lest LDC policymakers introduce capital controls:

Like these past episodes, the current surge in capital inflows is creating fragility in DCs. Deficit countries including Brazil, India, South Africa and Turkey are experiencing currency appreciations faster than surplus economies and relying on capital flows to meet growing external shortfalls. Many of those that have been successful in maintaining strong payments positions are facing credit and asset bubbles. Both categories are now exposed to the risk of instability to a greater extent than during the subprime debacle, though in different ways.

It is almost impossible to predict the timing of capital reversals or their trigger, even when the conditions driving the boom are clearly unsustainable. Still, it is safe to assume that the historically low interest rates in AEs cannot be maintained indefinitely and the current boom can be expected to end as interest rates start to edge up.

And what worse baddie is there under than the USA?

The US is now under deflation-like conditions and the Fed is aiming at creating inflation in goods and asset markets. But its policies are adding more to the commodity boom and credit expansion and asset price rises in DCs.

If commodity prices are kept up by strong growth in China, the continued policy of easy money in the US, along with speculation and political unrest in Arab countries, the Fed may end up facing inflation, but not the kind it wants. In such a case, capital and commodity booms may end in much the same way as the first post-war boom ended in the early 1980s — that is, by a rapid monetary tightening in the US even before the economy fully recovers from the subprime crisis.

The boom may also be ended by a sharp slowdown in China. As a result of a massive stimulus programme financed by cheap credits, large capital inflows and rising commodity prices, the Chinese economy is overheating. Monetary breaks now applied to control inflation could reduce growth considerably, particularly if it pricks the property bubble. The consequent fall in commodity prices could be aggravated by the exit of large sums from commodity futures, creating payments difficulties in commodity-rich economies and leading to extreme risk aversion and flight to safety.

Regardless of how the current surge in capital flows may end, it is likely to coincide with a reversal of commodity prices. The most vulnerable countries are those which have been enjoying the dual benefits of global liquidity expansion. Most of these are in Latin America and Africa and some are running growing deficits despite the commodity bonanza.

When policies falter in managing capital flows, there is no limit to the damage that international finance can inflict on an economy. Multilateral arrangements lack effective mechanisms that restrict beggar-my-neighbour policies by reserve issuers or enforce control on outflows at the source.

The task falls on recipient countries. But many developing countries still adopt a hands-off approach to capital inflows while others have been making half-hearted attempts to control them through taxes that are too low to match large arbitrage profits promised by interest rate differentials and currency appreciations. In either case taking capital controls much more seriously is now the order of the day.

It begs the question of who beggars which neighbours. It kind of beggars belief that we are still in roughly the same place as were when the G20 processes started in being rather more interested in apportioning blame than in devising mutually acceptable solutions. While I am obviously more attuned to the second version of events, I believe that such solutions do exist, but more on those later. Meanwhile, I remain relaxed about imposing such controls.