Textbook economics holds that free capital mobility is a source of stability, because it allows international investors to diversify risk and pursue the most profitable investment opportunities. Yet real world experience suggests that the vagaries of international capital flows can impart a huge amount of instability. The prime reason for this is that self-fulfilling expectations can get stuck on an explosive path and when they do they have the power to alter the underlying fundamentals big time.
When developed markets (DM) expected returns were very low, due to sluggish growth and easy policy rates as far as the eye can see, investors massively flocked towards emerging markets (EM) space in search of higher returns. This pushed up EM asset prices (including the exchange rate) and led to a massive increase in domestic credit growth in various countries. The flip side of this was widening of current account deficits which international investors only seemed happy to finance. The reason is that expectations of future asset price and exchange rate appreciation tend to feed on themselves because such capital inflows cause an endogenous improvement in domestic balance sheets. The value of private sector assets may well increase more than liabilities and solvency prospects seem better than they really are as the credit boom pushes up growth to unsustainable levels. Any attempt by the central bank to slow down growth may well backfire as higher policy rates only attract more capital inflows. In the textbook model, asset price appreciation is a stabilizing force because at some point valuations will become so unattractive that the inflow will dry up. However, in real life such a valuation ceiling does not exist. Asset prices can embark on an exponential growth path for a pretty long time.
Nevertheless, the imbalances that result from this cannot continue to grow forever. When the party stops, policymakers find out there is no valuation floor for domestic assets either. The increase in expected DM returns which started a year ago caused EM capital inflows to dry up. Once again EM central bankers are then presented with a Catch 22 situation. If they do not tighten monetary policy, the outflow may accelerate as exchange rate depreciations will feed expectations of further future depreciation. This happens because domestic balance sheets now suffer endogenous deterioration. Asset values decline while nominal debt levels remain the same and pessimism about growth and solvency prospects will create its own grim reality. In addition to this, runaway depreciation may also cause a substantial rise in inflation (expectations). If this happens, monetary policy will have to be tighter than in the case of stable expectations for a prolonged period of time to tame the inflation beast. Runaway capital outflows can thus easily trigger a self-fulfilling process that severely damages the underlying fundamentals. Once markets are in panic mode, they need a firm and decisive policy slap in the face to break this negative feedback loop.
Yet, one can very well understand why dealing this blow to markets is difficult because tightening policy is also not particularly attractive in an economy with excessive leverage. After all, higher interest rates as well as the concomitant growth slowdown will also conspire to reduce the solvency of the debtors and force them to stand and deliver. Yet, in the end this is often the least painful option, especially if the central bank acts early to stem the depreciation spiral. History shows that the cumulative rise in policy rates needed to break the depreciation feed-back loop is lower the more pro-active the central bank is in nipping the whole thing in the bud. In that case there is at least a reasonable chance that policy can be tightened relatively gradually which gives domestic agents time to adjust. In the case of runaway depreciation expectations draconic adjustments are forced upon them overnight which causes much bigger and longer lasting economic damage.
The good news is that (at least at the time that I am writing this) EM space seems to have succeeded in bringing about this more benign slow adjustment scenario, which is why we believe that the resolution of EM imbalances will not derail the global recovery. Having said that, the risks clearly lie in the direction of renewed EM market panic which could, for instance, be triggered by an increase in political and social unrest.
Willem Verhagen, ING Investment Management
