The global financial crisis and the subsequent flood of easy money unleashed by central banks in the advanced economies, particularly the US Federal Reserve, has raised contentious currency issues that open new fault lines in global macroeconomic stability and highlight the challenge to emerging markets of managing  volatile capital flows.

Emerging markets have been at the receiving end of most of the impact from the US Federal Reserve’s quantitative easing, or QE, aimed at containing the crisis.

The capital that surged into these economies in search of higher returns put upward pressure on their exchange rates, making their exports pricier and threatening growth. As countries competed to lower the value of their currencies, the term “currency war” has gained ground, capturing both the intensity of the issue and the hardening divide between emerging and advanced economies.

Currency issues are not new. The Plaza Accord in 1985 attempted to depreciate the US dollar against the Japanese yen, French franc, British pound, and the German mark in order to check the US current account deficit.

It is important for central banks to make sure that intervention is successful as a failed defence of the exchange rate is worse than no defence

However, the dollar over-corrected leading to the Louvre Accord in 1987 to halt its decline.

This time the issues are multilateral and complex.

Emerging economies hold QE responsible for the excessively volatile capital flows and exchange rate moves unrelated to fundamentals. They feel that the US has the privilege of enjoying funds at zero interest as the issuer of the world’s sole reserve currency and must accept the obligations that come with the role.

Advanced economies contend that QE is intended to stimulate domestic demand, that some spillover impact is unavoidable and they cannot be held accountable for it.

fed280They also say that capital flows are more due to ‘pull’ factors – the promise of return – than ‘push’ factors and that there is no evidence of real appreciation of emerging market currencies.

The US meanwhile argues that in return for the ‘exorbitant privilege’ of issuing the world’s sole reserve currency, it is also paying a price by running a fiscal deficit to meet the world’s demand for dollars even though the resultant strength of the dollar is hurting its export competiveness.

Although access to foreign money has benefits for recipient economies, the reality is that a country never gets the right amount of capital at the right moment.

The abrupt swings in cross-border flows in recent years were mostly driven by investors’ risk appetite, which shrank at times of crisis so that money gushed out of emerging markets and into safe havens. QE and other confidence-boosting events caused an about turn.

So far, central banks and governments in emerging economies have used two national-level options to manage the fallout: capital controls and currency intervention. Neither is completely benign and debate continues on which is to be used and under what circumstance and which is most effective.

Capital controls

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Central banking after the crisis: The challenges ahead

The crisis has dramatically altered the thinking on capital controls, which helped prevent emerging markets from adopting some of the financial products that proved toxic.

Capital controls may take the form of quantitative restrictions, such as a cap on foreign investment in a country’s bonds, or they may be price-based, such as taxes.

In India, for example, deposits from non-resident Indians, an important source of capital inflows, are steered by the interest rates that banks offer, a price variable.

External borrowing by Indian companies is controlled through both quantity and price variables.

Arguments about the effectiveness of capital controls are typically centred on three points: the first is that such controls do not alter the volume of flows, only their tenor. The second argument is that capital controls are easy to circumvent. And lastly, that such controls don’t work well to check outflows.

Currency intervention

ThinkAloud4Once considered sub-optimal, central bank intervention in the currency market has become a standard tool to defend currencies from appreciating due to the safe-haven impact.

There is substantial difference between intervention to fight appreciation and intervention to fight depreciation.

In countering appreciation, the central bank has, in theory at any rate, limitless capacity to sell its own currency for foreign currency. In this case, the issue is whether to leave all the local currency liquidity behind in the market, possibly causing inflation and asset price bubbles, or whether to mop it up by selling bonds, a process called sterilisation, in which case interest rates may go up, attracting even more flows and creating a vicious cycle.

Battling currency depreciation involves selling foreign exchange, or forex, reserves. The central bank’s capacity to intervene is, therefore, limited. What is more, the market is aware of this. The danger here is of losing a chunk of forex reserves without the domestic currency gaining.

It is important for central banks to make sure that intervention is successful as a failed defence of the exchange rate is worse than no defence.

There is also the risk of being gamed if the central bank is seen as targeting a specific exchange rate.

The challenge for the central bank is to intervene at unguarded moments and confuse the market so that it doesn’t impute a target rate to the action. Many countries say they are intervening in the forex market, not to target a particular rate but to manage the volatility in the exchange rate.

‘Impossible trinity’

The best way to understand the challenge of capital flow management is in terms of the “impossible trinity”, which says that a country cannot simultaneously maintain a free capital account, a fixed exchange rate, and independent monetary policy.

Advanced economies typically adopt a corner solution, forgoing one goal for the other two. For example, countries in the eurozone have a common currency and therefore a fixed exchange rate but they have forfeited monetary policy independence.

Emerging economies, on the other hand, opt for middle solutions such as a managed float of the exchange rate or a partially open capital account. Capital flow management must be informed by the impossible trinity.

Although there is agreement that capital flow management is a global issue and crucial for global stability, the advances so far have been restricted to thinking through country level responses. Many differences remain at the international level.

Where capital controls are concerned, the International Monetary Fund’s view is that they can be used “if macro policies are appropriate and after all other measures are exhausted.”

Emerging economies want the decision on the precondition for imposing controls to rest with individual countries.

The IMF also says that capital controls should not discriminate between residents and non-residents of a country. However, non-resident behaviour under pressure is different from that of residents, arguing against equal treatment.

The second issue relates to the forex reserves that countries hold as a war chest and as an instrument to inspire market confidence.

The IMF’s standard refrain is that holding reserves is wasteful and that countries should rely instead on the IMF.

However, approaching the IMF carries a stigma. Despite the emergence of many regional financial arrangements since the crisis, domestic reserves continue to take the top spot in the hierarchy of safety nets.

As for the world’s reserve currency, the US dollar, there has been much discussion about an alternative but one is yet to emerge.

Since large capital flows are inevitable in a globalizing world, any resolution to the issues caused by their volatile ebb and flow requires global consensus on sharing the burden of adjustment and policy coordination.

In a world divided by nation states with no constituency for the global view, this consensus is proving elusive.