Life is tough if you are a central banker in an emerging market country. Besides dealing with your own country’s macroeconomic conditions, you have to worry about external shocks to a much larger extent than your colleagues in industrialized nations. Further, often due to a history of poor macroeconomic management and hyperinflation, foreign investors still consider your country as a second-best option to be taken into account only after the more established industrialized countries.
Even though this description may sound crude and one-sided, the recent EM currency sell-off shows that it may accurately describe the current situation for many EMs. Indeed, the sharp reversal of capital flows out of emerging markets back into industrialized countries since Ben Bernanke’s first taper warning on May 21, 2013 demonstrates one thing: last years’ capital inflows into the developing world were not driven by a flight to quality, but simply by a flight to high(er) yields given the extremely low returns in the U.S. and other developed countries.
In this sense, last week’s emerging markets turmoil seems like one of the last chapters of a chronicle of an announced crisis. Indeed, it is well known that central bankers in developing countries have for years complained about the consequences that the U.S. Federal Reserve’s ultra-loose monetary policy and the resulting capital flows from the developed into the developing world may have for their economies. As Raghuram Rajan, the head of the Reserve Bank of India recently put it: “We complain when [capital] goes out for the same reason it goes in. It distorts our economies. And the money coming in made it more difficult for us to do the adjustment which would lead to sustainable growth and prepare for the money going out.” Short-term capital flows thus posit a risk to developing countries not only when they suddenly leave for other countries and generate sharp depreciations of the domestic currencies, but also when they slowly flow into those economies and contribute to overinvestment and higher inflation.
Can capital controls help EMs gain more macroeconomic independence and be less affected by volatile capital flows? Previous experience of some countries which have gone down this road, like Brazil and South Korea, seems to support this notion. In fact, given the (at least partially) successful experience on capital controls by certain countries, EMs should think of more sophisticated ways to implement such measures, for example through the design of pro-cyclical capital control rules which would automatically adjust to the need and availability of foreign capital according to predefined macrofinancial conditions.
Unfortunately, instead of following this or a related approach to ease the pressure on their currencies, some EMs like Turkey have opted for a policy of interest rate increases. While the rationale for a hiking rates is straightforward, the experience of previous episodes of financial turmoil suggests that interest rates increases are seldomly successful in bringing currency sell-offs to a lasting halt, and this previous experience has been corroborated by the recent developments. Furthermore, the main problem relying on interest rate hikes is that it is a double-edged sword: While it may (but most probably will not) succeed in repelling a currency attack, it will most certainly harm domestic economic activity through conventional channels of the monetary policy transmission mechanism. Obviously, the acuteness of trade-off is quite situation- and country-specific. While in the East Asian crisis the significant amount of unhedged foreign currency debt existing in the majority of countries forced them to try to defend their respective exchange rates at all costs, in the current situation these conditions are not met. Therefore, interest rate hikes are likely to do more harm than good.