From easy money to hard landing

Before the world economy has been able to fully recover from the crisis that began more than five years ago, there is a widespread fear that we may be poised for yet another crisis, this time in emerging economies.

The signs of external financial fragility in several emerging economies have been visible since the beginning of the financial crisis in the US and Europe. The South Centre has constantly warned that the boom in capital flows that had started in the first half of the 2000s and continued even after the Lehman bank collapse is generating serious imbalances in the developing world along with the danger of a sudden stop and reversal.

Policy choices in advanced economies, notably in the US as the issuer of the main reserve currency, in response to the crisis are key to understanding what is going on. Reluctance to remove the debt overhang caused by the financial crisis through timely, orderly and comprehensive restructuring, and an abrupt turn to fiscal austerity after an initial expansion, has meant an excessive reliance on monetary means to fight the Great Recession, with central banks entering uncharted policy waters, including zero-bound policy interest rates and the acquisition of long-term public and private bonds (quantitative easing).

This ultra-easy monetary policy has not been very effective in reducing the debt overhang or stimulating spending. It has, however, generated financial fragility, at home and abroad, notably in emerging economies. In several emerging economies, policies pursued in recent years have no doubt made a significant contribution to the build-up of external vulnerability. Many commodity-dependent economies have failed to manage the twin booms in commodity prices and capital flows that started in the early years of the millennium and continued until recently, after a brief interruption in 2008-09.

Policy response

These countries, and several others, have stood passively by as their industries have been undermined by the foreign exchange bonanza, choosing, instead, to ride a consumption boom driven by short-term financial inflows and foreign borrowing by their private sectors and allowing their currencies to appreciate and external deficits to mount. Hastily erected walls against destabilising inflows have been too little and too late.
The International Monetary Fund (IMF), the organisation responsible for safeguarding international monetary and financial stability, has also failed to promote judicious policies not only in major advanced economies, but also in the South. It has been unable to correctly identify the forces driving expansion in emerging economics and joined, until its recent U-turns, the hype about the ‘rise of the south,’ arguing that major emerging economies are largely decoupled from the economic vagaries of the North and have become new engines of growth, thereby underestimating their vulnerability to shifts in policies and conditions in the North,
notably the US.

Policy response to a deepening of the financial turbulence in the South and tightened balance of payments should be similar in many respects to that recommended by the South Centre in the early days of the Great Recession. The principal objective should be to safeguard income and employment. Developing countries should not be denied the right to use legitimate trade measures to rationalise imports through selective restrictions in order to allocate scarce foreign exchange to areas most needed, particularly for the import of intermediate and investment goods and food.

Emerging economies should also avoid using their reserves to finance large and persistent capital outflows. Nor should they rely on borrowing from official sources to maintain an open capital account and to remain current on their obligations to foreign creditors and investors. They should, instead, seek to involve private lenders and investors in the resolution of balance-of-payments and debt crises and this may call for, inter alia, exchange restrictions and temporary debt standstills. These measures should be supported by the IMF, where necessary, through lending into arrears.

The IMF currently lacks the resources to effectively address any sharp contraction in international liquidity resulting from a shift to monetary tightening in the US. A very large special drawing rights (SDR) allocation, to be made available to countries according to needs rather than quotas, would help. But a greater responsibility falls on central banks in advanced economies, notably the US Federal Reserve, which can and should – as the originators of destabilizing impulses that now threaten the South – act as a quasi-international lender of last resort to emerging economies facing severe liquidity problems through swaps or outright purchase of their sovereign bonds.

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