Global capital is on the move. As
ultralow interest rates in industrial countries send
capital around the world in search of higher yields,
a number of central banks in emerging markets are
intervening heavily, buying the foreign capital
inflows and re-exporting them in order to keep their
currencies from appreciating.
Others have been imposing capital
controls of one stripe or another. In recent weeks,
Japan became the first large industrial economy to
intervene directly in currency markets.
Why does no one want capital
inflows? Which intervention policies are legitimate
and which are not? If it continues unabated, where
will all this intervention end?
The portion of capital inflows that
is not re-exported represents net capital inflows
which are used to finance domestic spending on
foreign goods. Countries do not like capital inflows
as it causes more domestic demand to leak
outside. Capital inflows encourage further spending
on foreign goods as domestic producers become
uncompetitive as they often cause the domestic
exchange rate to appreciate.
In addition, countries do not like
foreign capital inflows because some of it might be
hot or dumb money, eager to come in
when foreign interest rates are low and local asset
prices are rising, and quick to leave at the first
sign of trouble or when opportunities back home
Volatile capital inflows induce
unpredictability in the recipient economy, making
booms and busts more pronounced than they would
However, as the saying goes, it
takes two hands to clap. If countries could maintain
discipline and limit spending by their households,
firms, or governments, foreign capital would not be
needed and could be re-exported easily without
affecting the recipient economy much. Problems arise
when countries cannot – or will not – spend
Countries can overspend for a
variety of reasons. The stereotypical Latin American
economies of yesteryear used to get into trouble
through populist government spending, while the East
Asian economies ran into difficulty because of
excessive long-term investment.
In the United States (US) in the
run-up to the current crisis, easy credit,
especially for housing, induced households to spend
too much, while in Greece, the government borrowed
its way into trouble.
Unfortunately, so long as countries
like China, Germany, Japan, and the oil exporters
pump surplus goods into the world market, not all
countries can trim their spending to stay within
their means. Since the world does not export to
Mars, some countries have to absorb these goods and
accept the capital inflows that finance their
In the medium term, over spenders
should trim their outlays and habitual exporters
should increase theirs. Yet, in the short-term, the
world is engaged in a gigantic game of passing the
parcel, with no country wanting to take the habitual
exporters’ goods and their capital surpluses.
This makes current
beggar-thy-neighbour policies so destructive:
although some countries eventually have to absorb
the surpluses and capital, each is trying to avoid
Which policy interventions are
Any policy of intervening in the
exchange rate, or imposing import tariffs or capital
controls, tends to force other countries to make
greater adjustments. China’s exchange rate
intervention probably hurts a number of other
emerging market exporters that do not intervene as
much and are less competitive as a result.
Yet, industrial countries, too,
substantially intervene in markets. While US
monetary policy intervention (monetary policy is
also an intervention) has done little to boost
domestic demand; it has spurred domestic capital to
search for yield around the world.
The dollar would fall substantially
– encouraging greater exports – were it not for
foreign central banks pushing much of that capital
right back by buying US government securities.
All this creates distortions that
delay adjustment; exchange rates in emerging markets
are too low, slowing their move away from exports,
while the ease with which the US government is being
financed creates little incentive for US politicians
to reduce spending over the medium term.
Rather than intervening to obtain a
short-term increase in their share of slow growing
global demand, it is sensible for countries to make
their economies more balanced and efficient over the
medium term. That will allow them to contribute to
increasing global demand in a sustainable way. In
order for private consumption to increase, China
must move more income to households and away from
To produce more of the high quality
knowledge and service sector exports in which the US
specialises, the country must improve the education
and skills of significant parts of its labour force.
Higher incomes would boost US savings, reducing the
dependence of households on debt, even as they
maintain consumption levels.
Unfortunately, all this takes time,
and citizens who are impatient for jobs and growth
are pressing their politicians. While countries
around the world are embracing short-sighted
policies that cater to the immediate needs of
domestic constituencies, there are exceptions.
Thus far, India has eschewed
currency intervention even while opening up to
long-term rupee debt inflows, in an attempt to
finance much needed infrastructure projects. India’s
willingness to spend when everyone else is
attempting to sell and save entails risks that need
to be carefully managed.
However, it also provides a glimpse of what the
world could achieve collectively.
Beggar-thy-neighbour policies will succeed only in
making beggars of everyone.