Author: Khurshed Alizoda
Business
cycles are known to be more volatile in emerging market economies (EMEs). That
is, the growth rates of EMEs are higher than the growth rates of developed
countries. At the same time, during recessions the drop in output is also
larger. EMEs are more vulnerable to external
shocks in the world economy. The integration of the most EMEs to the global
financial markets has been very painful. Relatively unorganized and ripe
financial market structure of these economies make the integration process long
and challenging. The lacking capacity of economic and financial institutions
proves out to be incapable to resolve these challenges. However, several
economies did manage to come up with the right mix of policies that helped to
smoothen the process of financial globalization. The example of East Asian
countries provides useful feedback that the standard fiscal and monetary
policies are not sufficient on their own in stabilizing the economy which is
vulnerable to instant shocks. Rather the constant trade-offs between different
policies and tools are vital in achieving the desired stable growth.
With
increasing globalization of the world economy, the economic policy changes in major
developed economies may have significant effects on EMEs’ economies.
Every time when Fed or ECB announces their decision on policy rates, high volatility can be observed in financial markets throughout the world,
especially in developing countries. Fed’s hawkish long run outlook on interest
rates might result in significant financial outflow from EMEs. Since most of
EMEs’ growth of output depends on these capital inflows, the resulting scenario
will hurt the economy. In this case, financial “trilemma” becomes a “dilemma”, since independent monetary policies are possible, regardless of the fixed or
flexible exchange rate regime, if and only if the capital account is regulated
(Rey, 2013). Moreover, Obstfeld (2014) points out the importance of
independence of domestic short run nominal interest rates in EMEs from foreign
nominal interest rates to curb themselves from external shocks and
fluctuations. Here, the type of exchange rate regime also gains its importance.
As a result
of increasing rates of inflation throughout the world in 1970s Bretton Woods
system fell, and developed countries abandoned fixed exchange rate regime.
Floating exchange rate regime became a new standard in automatic stabilization
process from external shocks. However, flexible exchange rates “…almost never
provide full insulation against disturbances from abroad” (Obstfeld, 2014).
Regardless the insufficiency of flexible exchange rate in protecting the
economy from different external shocks it yields better outcomes than the fixed
exchange rate regime. But still, floating exchange rate regimes in EMEs are more
volatile and vulnerable to regular speculative attacks. One of the recent examples being the Argentine peso.
Asian financial crisis
of late 1990s forced most East Asian countries to abandon fixed exchange
rate regime. As a result, floats of their currencies were associated with very
sharp fluctuations in their values. However, macro prudential tools again
played a significant role in stabilizing their economies in crisis period and
the rebound from the crisis was fast enough. Another evidence indicating that
EMEs need more effective mix of policies that go beyond the standard policies or
monetary trilemma.
Figure 1. Coping with
Surges in Capital Inflows: Macroeconomic and Prudential Considerations
Source:
“Capital Inflows: The Role of Controls” IMF Position Note.
EMEs have
seen critical surge in financial capital inflows in the process of financial
liberalization. Relatively high interest rates compared to developed countries
have been attracting investors. Most countries enjoy short term capital inflows
that get the economy going but in the long run they are caught in instabilities
or boom and bust cycles. However, some developing countries were successful in
managing financial capital inflows in a way that avoided serious drawbacks.
Those who were successful did not rely on a single instrument but rather they
used policy mixes. In the times of surge in serious financial capital inflows
exchange rate appreciation was allowed and fiscal policy was tightened to curb
the economy from overheating. According to Calvo, Leiderman and Reinhart
(1996): “To moderate the volume of the inflows and lengthen their maturities,
exchange rate flexibility was increased and measures to curb inflows were
implemented.”(p.137). But it does not mean that all financial capital inflows
hurt the economy. The nature of capital inflows play an important role in
choosing the right mix of policy tools. According to Blanchard (2013),
“Exogenous bond flows appear to have small negative effects on output, while
exogenous non-bond flows appear to have a positive effect.” (Table 1). That is,
non-bond flows decrease cost of the borrowing and may yield expansionary impact
on the economy.
Source: “Are Capital Inflows Expansionary or Contractionary?”,
Blanchard, O.E.
As for the
institutions, to carry out credible mix of policies, the healthy and efficient
institutions play very important role. Financial globalization will hurt EMEs
if they lack strong economic institutions that have a capacity to face
stringent challenges. Making the right call in volatile environment with too
many options on hand is not an easy task. Recent macro prudential regulations
and reforms encouraged by IMF and the World Bank may make EMEs’ life easier in
financial globalization. But still, to apply reforms and regulations efficiently
the quality of economic institutions is vital.
Financial
globalization, of course, has positive externalities for the economies that
strive to join financial world and integrate their economies. Raising all the
restrictions on capital flow and becoming closer to financial world is seen as
a modern trend by many economists. However, harm from financialization is
larger than its benefits for EMEs. Most of the developing countries possess a
fragile financial system that is not ready for financial openness instantly. To
make financial integration a benefit for the economy EMEs should carry out
various reforms and apply regulations to control turbulent processes.
Floating
exchange rate regime is important as a stabilization mechanism. Macroeconomic
policies are very important in reaching clear targets. However, it is not
enough to rely on a couple of standard policies but to use comprehensive mix of
policies that might go beyond monetary and financial trilemmas to stabilize the
economy. Constant trade-offs between policies make this process very
challenging, since the tools and goals are many. And those who succeeded in
the integration to financial world worked hard on increasing the quality of
their economic institutions. Thus, these healthy institutions used the
appropriate mix of macroeconomic policies and macro prudential tools to battle
volatility and uncertainty brought by financial globalization. Finally, it can
be said that financial globalization hurts emerging economies if they are not
ready to challenges brought by it. EMEs will encounter various policy choices and trade-offs that won’t be easy to choose from without a clear strategy, and not to mention the possible political instability brought by election cycles, that may reverse the long-run projections.
Reference
Blanchard, O.E. (2016) Are Capital Inflows
Expansionary or Contractionary? Theory, Policy Implications and Some Evidence,
NBER WP No. 21619.
Calvo,
Guillermo A., Leonardo Leiderman, and Carmen M. Reinhart. “Inflows of Capital
to Developing Countries in the 1990s.” Journal
of Economic Perspectives 10 (Spring 1996): 123-139.
Obstfeld,
Maurice. (2014) “Trilemmas and Tradeoffs: Living with Financial Globalization.”
University of California, Berkeley, NBER, and CEPR.
Ostry,
J. A. Ghosh, K. Habermeier, M. Chamon, M. Qureshi, and D. Reinhardt (2010)
“Capital Inflows: the Role of Controls” IMF Position Note.
Rey,
Helene. (2013). “Dilemma not Trilemma: The Global Financial Cycle and Monetary
Policy Independence.” In Global
Dimensions of Unconventional Monetary Policy, 2013 Jackson Hole Symposium
Proceedings. Kansas City, MO: Federal Reserve Bank of Kansas City, 2014.
