Capital flows are a big concern

In Brazil, officials have twice raised taxes on foreign investors. Even in South Korea, host to this week’s Group of 20 meeting, pressure is building on the government to take similar steps. As the leaders of the 20 major economic powers gather in Seoul, an increasing number of them have either imposed curbs or are in the process of doing so to slow the torrent of hot money into their markets.

Over the years, foreign capital flowing into emerging markets has played a crucial role in helping finance roads in India, factories in China and buyers of luxury cars in Brazil. But as the sums have compounded and led to more market volatility, fast-growing countries have begun to worry that short-term investment will push up the value of their currencies, make their goods less competitive in the global market, and lead to asset bubbles that will be painful to deflate.

Once a core policy commandment of the so-called Washington consensus and held dear by the United States Treasury, the International Monetary Fund (IMF) and global investment banks, the belief that unfettered capital flows are a boon for everyone, including the country on the receiving end, has been dealt a major blow.

Short-term investment is now increasingly viewed as something that needs to be controlled. “The world has learned about the perils of free market finance — global financial liberalization just does not work as advertised,” said Harward’s John F Kennedy School of Government political economy professor Dani Rodrik.

Still, the risk remains that as capital controls are adopted by more countries, a result will be a series of competitive devaluations, which could drive away overseas investors and lead to a rout of once-buoyant stock markets. Many countries are discussing additional steps because they fear that the Federal Reserve’s latest bid to revive the United States economy by pumping an additional $600 billion into the banking system will further weaken the dollar and send more money into fast-growing markets.

The latest restrictions are as various as taxes on bond and equity flows and extended rules on how quickly short-term capital may be repatriated. Emerging markets have been grappling all year with the consequences of a flight of investor capital from rock-bottom interest rates in Western countries in search of higher yields. Short-term capital investment in emerging markets — largely in stock markets, which are at an all-time high — is expected to hit $458 billion this year, the highest figure since 2007 when $784 billion flowed into these markets, according to the Institute of International Finance.

Under what conditions countries should impose controls on investment is a matter of some dispute. The United States, with its big budget deficit, aggressive monetary easing and weakening currency, may struggle to be the arbiter.  A new study by the Peterson Institute for International Economics offers a suggestion. It argues that policy makers need to distinguish between types of capital controls. There are the ones deployed by countries like China and a few other Asian export powerhouses intended to keep their currencies artificially low. They contrast with those being applied by Brazil and others that are intended to avoid asset bubbles and prevent their currencies from rising too quickly.

China, which the authors estimate encourages its renminbi to remain at least 20 per cent undervalued against the dollar, and Singapore, where the undervaluation is even steeper at 33 per cent, are “violating their international obligation” to avoid competitive devaluations, the institute concluded. As for fast-growing economies like Brazil and Turkey, where currencies are now overvalued against the dollar by an estimated 9 per cent and 16 per cent, respectively, the paper concludes that they are justified in raising selective barriers.

After the Asian crisis in 1997 and the Russian market collapse in 1998, the notion that such flows were an unquestioned good began to be challenged. Of course, at the time, many countries were concerned mostly about capital flight and its effect, not inflows. Despite China’s success in maintaining tight control over its currency and the recent actions of Taiwan, Brazil and others, not all emerging markets are erecting barriers. In India, where a record-breaking stock market has lured billions of dollars, officials have said that they do not intend to impose new restrictions.

Similarly, policy makers in booming Turkey say they will not impose controls, despite calls for action from some of the country’s exporters.