Opinion

The risk of high capital flow

By Yilmaz Akyuz (China Daily)
Updated: 2011-04-20 17:45

During the early days of the subprime turmoil, then Citigroup chief executive Charles Prince said: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

Indeed, international finance appears to have picked up the pace of the music in developing countries, including China. While many advanced economies continue to encounter debt deflation, financial stringency and risks of insolvency, developing countries are facing problems of asset inflation, credit expansion and currency revaluation. Except for a brief interruption in 2008, developing countries have been getting large capital inflows as major advanced countries respond to the crisis caused by excessive liquidity and debt by creating still larger amounts of liquidity to bail out troubled banks and governments, lift asset prices and lower interest rates.

Quantitative easing (QE) and close-to-zero interest rates are now generating a surge in speculative capital flows into countries with higher interest rates and better growth prospects, creating bubbles in foreign exchange, asset, credit and commodity markets.

This is the fourth post-war capital flow boom in developing countries. The previous booms also started under conditions of rapid liquidity expansion and exceptionally low interest rates in the United States, and all ended with busts. China is now a main destination of speculative capital.

During the subprime boom, emerging European economies received as much foreign capital as China and other developing countries in Asia despite their comparatively small economic size. Now, given the financial instability in Europe, investors have increasingly turned to Asia and commodity-rich economies. According to the Institute of International Finance, private inflows to China reached an all-time high of $227 billion in 2010. Despite restrictions, the State Administration of Foreign Exchange estimates that one-third of that was "hot money". And the share of overseas direct investment (ODI) in real estate was 23 percent, up 10 percent from 2006.

Although China's investment abroad has been increasing, too, particularly in commodity sectors, much of that has been absorbed in reserves, which are reported to have increased by almost $200 billion in the first quarter of 2011, exceeding $3 trillion in total. This is mainly because of the inflow of hot money as ODI remained moderate and China ran a trade deficit in the first quarter, the first time in seven years.

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Unlike other major emerging economies in payment deficit such as Brazil, India, South Africa and Turkey, China has been able to moderate the revaluation of its currency. But this is giving rise to liquidity expansion because it is only partly sterilized. The combination of the surge in capital inflow and the massive stimulus package has been overheating the economy, creating inflation in property as well as product markets and posing the risk of a hard landing.

QE and close-to-zero interest rates in developed countries have been destabilizing China through the commodity channel. As the second largest importing country, China has no doubt been a major factor in the upturn of commodity prices since mid-2009. But this has been accentuated by increased speculation in commodity futures because liquidity, too, has been channelled toward commodity markets in a search for yield.

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 developed economies cannot be maintained indefinitely and the current boom can be expected to end when interest rates in the US start to edge up. It can also end as a result of a balance-of-payments crisis or a domestic financial turmoil in a major emerging economy, infecting the developing world even without tightened monetary conditions in the US.

The US is now in a deflation-like condition and the Federal Reserve is trying to create inflation in goods and asset markets. But its policies are adding more to the commodity boom, and credit and asset bubbles in developing countries, including China. If commodity prices are kept up by strong growth in China, the Fed could 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.

If, on the other hand, Chinese growth slows down considerably because of the monetary breaks now applied to control inflation, commodity prices may start falling sharply, particularly if large sums exit from commodity futures. This could create payment difficulties in commodity-rich economies and lead to extreme risk aversion and flight to safety.

Regardless of how the current surge in capital flows would end, it is likely to coincide with a reversal of commodity prices. The most vulnerable countries are those that have been enjoying the dual benefits of global liquidity expansion - the boom in commodity prices and capital inflows. Most of these are in Latin America and Africa and some are running growing deficits despite the commodity bonanza. The current situation thus invokes the memories of the 1980s when Mexico, a country that had enjoyed the twin booms in the preceding period - the hike in oil prices and expansion of international bank lending - was the first to fall into crisis.

Exporters of manufactured goods with strong payments and reserve positions, including China and smaller East Asian economies, are not seriously exposed to the risk of a currency and payments crisis. For them, an orderly slowdown in capital flows and softening of commodity prices could even bring benefits in terms of inflation, exchange rates and external payments. But the credit and asset bubbles under way expose them to a risk of a sharp asset correction and economic downturn, even more so than seen during the Lehman Brothers' collapse - only this time they would be in a much weaker position to respond.

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-neighbor policies by reserve issuers or enforce control on outflows at the source. The task falls on recipient nations. But many developing countries still adopt a hands-off approach to capital inflows, while others have been making only half-hearted attempts. In either case taking capital controls much more seriously is now the order of the day.

The author is chief economist of South Centre, an intergovernmental think tank of developing countries headquartered in Geneva.