Pulling the cloak off emerging imbalances

Hot money is flowing out of emerging markets as the US Federal Reserve moves closer to an actual tapering, and the withdrawals are starting to bite in places like India and Indonesia.


Turmoil in the emerging markets prompts an uncomfortable thought. Has the Federal Reserve’s quantitative easing program done more to damage emerging markets than to boost the US recovery? It would be ironic indeed if the chief impact of the Fed’s unconventional measures turned out in hindsight to have been outside the US.

Maybe the implication is a little harsh. We cannot be certain where the US economy would be if the Fed’s asset purchasing programs had not taken place, but I suspect the recovery would have been more feeble or non-existent without this central bank activism, even if the impact of more recent purchases has been minimal. Its chief effect was to offset deleveraging that would otherwise have caused deflation. What we know for sure, though, is that interest rate repression in the US was designed to increase risk appetite, and in this the Fed has been outstandingly successful. A notable consequence was a huge flow of hot money from the US into emerging markets.

This unintended consequence of QE in the developing world has in some cases been morally hazardous. Ready access to external capital has permitted imprudently large budget deficits and made it easier for politicians to put off much needed structural reform, India being the most striking case in point. At the same time the inflow of capital has driven up currencies and encouraged overconsumption, together with increased dependence on foreign capital as the external account has weakened.

Since the great QE tapering debate began in May, external capital addicts such as India, Brazil, Indonesia, Turkey and South Africa have been badly hit by a reversal of the flow. The result has been falling asset prices, rising interest rates and a reduction in growth prospects. There is a risk that the decline in currencies becomes self-feeding, causing inflation to accelerate and precipitating panic-induced credit crunches. There is a strong echo of the 1997-98 Asian crisis.

The morally hazardous implications of central bank activism are not, incidentally, confined to the developing world. The European Central Bank’s announcement of its outright monetary transactions program just over a year ago was highly successful in bringing down government bond yields in over-indebted eurozone countries. Yet it took the politicians off the hook. Structural reform is on hold in France, Italy and much of southern Europe (A euro crisis on German ice, July 18).

Yet the central banks should not be saddled with all the blame. The underlying problem is one identified by the economist Mancur Olson. In analysing the reasons why nations decline, he concluded that countries tended to fall hostage to small distributional coalitions formed by producers, unions and other groups seeking to influence policy in their favour. Their agenda is often protectionist, anti-technology and anti-growth. And since the beneficiaries of such lobbying are small in number while the costs are spread widely around the population, it is hard to build countervailing public resistance. Distributional coalitions of this kind accumulate over time, Olson argued, ultimately rendering economies sclerotic.

That, in essence, is the story of the Japanese economy since its export-led growth model blew up over 20 years ago. Its biggest problem is that consumer income is too low while the corporate sector holds on to a disproportionate share of gross domestic product thanks largely to excessive depreciation and low payout ratios. That longstanding imbalance reflects the extraordinary lobbying power of Japanese business. Nothing in Prime Minister Shinzo Abe’s reform program addresses the issue (Is Abenomics building a false economy? May 31). That may partly be a failure of analysis, but the lobbying power of businesses must be a contributory factor.

A similar point can be made about China. Its export and investment-led growth model has come to the end of the road much earlier than in Japan. The new Chinese administration appears more committed than its predecessor to shift the balance of the economy towards consumption and to eliminate the subsidy paid by households to the corporate sector. This will be achieved by, among other things, liberalising financial markets. Yet there are powerful voices in state-owned industry, finance and local government opposed to change. So far little rebalancing of the economy has taken place.

Looking across the emerging market sector, the reversal of capital flows should not be as damaging as in the past. Many economies are healthier, with stronger external accounts and higher reserves. The composition of capital inflows has latterly been tilted towards foreign direct investment, which is relatively stable. Yet for the capital junkies, things will get worse before they get better. The Fed will be offering no help. The best hope for those having difficulty rolling over short-term debt is that capital flight will shock them into structural reform. They should not let this crisis go to waste.

Copyright The Financial Times Limited 2013

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