In the line of rogue US firepower

Lowy Interpreter

With the postponement of the quantitative easing taper and the adjournment of the US debt-ceiling threat, financial markets have calmed down. India and Indonesia – the two Asian countries most affected by the panic – can relax, at least for the moment.

There are lessons in the recent experience, although not all observers draw the same conclusions. First, how should we interpret the post-2008 growth path and the immediate prospects? Asian emerging countries are certainly growing more slowly than in the hot-house policy-stimulus environment of 2010. But this slowing actually occurred two years ago. The Fund’s estimate for this year and its forecast for next year are both about the same as the actual rate of growth last year – all within the range 6.3-6.5 per cent.

Not only is the growth rate stable, but the pace is quite respectable. At this rate, income doubles in just over a decade. Of course some of these countries could do better, but this is not too bad.

Second, there is the lesson of the last six months: US policy adjustments can be disruptive for emerging economies. Financial markets are the conduit. Sharp movements in exchange rates and interest rates are the manifestation, and these in turn disrupt domestic confidence and investment.

Exchange rates fell sharply in India and Indonesia but in the end the falls were not much greater than occurred in Australia. The difference is that confidence was not undermined in Australia. In fact, the fall was seen as a positive factor, restoring international competitiveness.

Indonesia and India are not yet ready to judge these big shifts with the same equanimity. While both these countries have been given a reprieve, the story is not yet over. The US will have to do its QE taper at some stage and the arm-wrestle on debt will resume early next year. In Europe the banking system is still frail and the peripheral countries are ripe for renewed crisis. Can the emerging economies seek protection by asking the advanced economies not to repeat their damaging policies?

In a word: no. The emerging economies should assume they are on their own.

Rather than special pleading in international forums, their best bet is to prepare themselves. Indeed, recent tribulations have strengthened the hands of the reformers. In India, Raghuram Rajan, the new rock-star central bank governor, was able to push through unpopular interest rate increases and capital account reforms. In Indonesia, interest rates were raised and there are even whispers about another petrol price increase to reduce the ludicrous subsidy which costs the budget as much as health spending.

Just as reassuring, the external stresses seem to have pushed aside the grandiose infrastructure project to build a bridge across the Sunda Strait, passing close to the still-active remains of the Krakatau volcano that shook the world in 1883.

In both India and Indonesia, part of the policy response to the recent volatility involved market intervention to support the currency. This sort of intervention has been consistently derided both by academics and the international agencies, but is now getting support from surprising quarters and wary endorsement from the IMF.

As usual, however, the Fund speaks with multiple voices and the dominant ones are still stuck on the old morality tale: if a country’s domestic policies are virtuous (flexible exchange rates, firm fiscal policy and structural reform), it will be saved, even in a volatile world.

It’s as if the Fund, having formerly been a strong advocate of chastity, now has no sensible advice to offer in a more permissive world. ‘Flexible currencies, alongside guarded use of FX intervention to smooth volatility and ensure orderly market functioning, should be viewed as a principal line of defense in the face of concerted capital outflows.’

On the surface, this sounds sensible enough, but as operational advice in the context of volatile capital flows, it’s misleading. The problem with the exchange rate is not day-by-day volatility, but substantial overshooting which persists long enough to disrupt the real economy. ‘Smoothing volatility’ is the sort of advice that led Indonesian authorities to intervene too early in defending the rupiah when it was adjusting to accumulated imbalances. A different approach would accept the necessary fundamental adjustment but provide a strong message to the market that the authorities stand ready for substantial intervention if the exchange rate overshoots.

The same ambiguities arise with the Fund’s transition from doctrinal advocacy of free capital flows to its recent recognition that capital flows can be disruptive. The new World Economic Outlook paper invokes the irrefutable authority of Adam Smith to assure us that market forces will keep things smooth. When foreigners are fleeing, locals will step in to stabilise the situation. But it draws a long bow when it cites the actions of Malaysia’s government-run pension fund as a prime example of private-sector stabilising counter-flows. The emerging economies will do well to take their own counsel here.

 Originally published by The Lowy Institute publication The Interpreter. Republished with permission.