'Storms gather over emerging economies’. So says the Financial Times editorial. This latest alarm reflects a concern that the tapering of the US Fed's quantitative easing (QE) policy will set off sudden capital outflows. The World Bank spells out this QE risk in hand-wringing detail in its latest World Economic Prospects.
Just how worried should we (and the emerging economies) be? The problem is not QE as such, but the volatility of international capital flows.
If we look back at the last QE scare (in May last year, when US Fed Chairman Bernanke hinted that QE bond purchases would be tapered off), the volume of outflows was actually quite small. The Institute for International Finance (the global bankers' lobby group, which does some excellent research) estimates that the 'taper tantrum' caused outflows of US$73 billion in stocks and bonds from emerging economies. This is equal to just a couple of months' inflow. Developing economies hold US$9 trillion of foreign exchange reserves. The foreign exchange reserves of Indonesia alone are well in excess of the outflows from all the emerging economies taken together.
The wider concern is that if such modest outflows can cause large changes in exchange rates, equity prices and bond yields, and dampen the 'animal spirits' which drive growth, what if the outflows were much larger, as they were in the 1997 Asian crisis? This graph shows gross private capital inflows into developing countries since 1990:
The taper tantrum hardly registers here (it's in the last two observations), overshadowed by other huge fluctuations. The main driver is wide (it's tempting to say 'wild') swings of market optimism and pessimism. Note the huge surge in credit inflows driven by the mindless optimism of 2004-2007, then the sudden reversal in the face of the 2008 financial crisis, followed by the speedy revival when financial markets recognised that the emerging economies were not much affected by the crisis, retreating sharply again when Greece hit the wall in 2010.
There's not much policy-driven narrative here. Policy (whether QE or monetary policy) has a substantial influence only in as far as it triggers changes in global confidence.[fold]
The central issue is that much of this inflow is flighty short-term credit and portfolio flows responding to 'risk-on/risk-off' signals, with the investor-lemmings all looking for some sign of when to turn around and run in the opposite direction. Even relatively trivial news (such as Bernanke's May speech) is enough to trigger a reversal in confidence. The investors are not looking at the fundamentals, but just looking sideways at each other, ready to get out ahead (they hope) of the crowd.
What might be done? As usual, the emerging countries will have to find their own solutions, even if the volatility is often driven by global events such as the Greek debt collapse. There are plenty of 'black swans' out there waiting to startle the global investment community. For example, the euro is being held together by ECB President Draghi's promise to 'do whatever it takes', a promise which remains untested. And of course the QE taper is just one small aspect of the far weightier task of actually unwinding QE and getting interest rates back to normal levels.
No one is arguing that emerging economies should cut themselves off from global finance. That said, emerging economies that chronically run into domestic problems (often political, as is happening currently in Argentina, Turkey and perhaps Brazil), can expect no sympathy (or patience) from foreign investors. If a country can't run a tight ship and live strictly within its means (small budget and external deficits, low inflation, stable politics), then it would be better off without the short-term foreign flows.
The volatility in the graph explains why capital flow management (what used to be derisively called 'capital controls') is being added to the policy armoury in emerging economies. Credit and portfolio flows (shown here in yellow and darker blue) are so ephemeral as to be of dubious value. The valuable inflow is from foreign direct investment (light blue), rising pretty steadily through all the financial market's flip-flops of confidence.
The free-market doctrines which dominated financial thinking in the pre-2008 decades are no longer going unquestioned. Regulations which would put some sand in the wheels of international capital flows are finding high-level support. Adair Turner, former head of the UK financial supervisor, identifies the problem as 'too much of the wrong sort of capital flow'.
Direct controls (usually called macro-prudential measures) which might reduce the marked pro-cyclicality of finance are finding widespread favour, although their effectiveness is yet to be properly tested. However these work out in practice, intervening in foreign exchange markets and actively discouraging volatile components of capital inflow no longer seem to be such heretical ideas.