Economics:The Capital-Flow Conundrum * Mareeg.com somalia, World News and Opinion.
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Economics:The Capital-Flow Conundrum

11 November 2013 (Mareeg.com)ITHACA – In recent months, emerging economies have experienced capital-flow
whiplash. Indications that the US Federal Reserve might “taper” its quantitative
easing (QE) drove investors to reduce their exposure to emerging markets, sharply
weakening their currencies and causing their equity prices to tumble. Now that the
taper has been postponed, capital is flowing back in some cases. But, with little
influence, much less control, over what comes next, emerging economies are still
struggling to figure out how to protect themselves from the impact of a Fed policy
reversal.

When the Fed initially hinted at its intention to taper QE, policymakers in some
emerging economies cried foul, but were dismissed by advanced-economy officials as
chronic complainers. After all, they initially rejected the very policies that they
are now fighting to preserve.

But emerging-market policymakers’ criticisms do not reflect an inconsistent stance;
in both cases, the crux of their complaint has been volatility. They have already
attempted to erect defenses against the potentially destabilizing effects of
advanced-country monetary policy by accumulating foreign-exchange reserves and
establishing capital controls. Now they are calling on their central banks to ensure
stability by, for example, raising short-term lending rates.

But this approach fails to address the underlying issue – and misdiagnosing the
problem could have far-reaching consequences, not only leading to ineffective
solutions, but also possibly causing severe distortions for specific economies and
the global financial system as a whole. In order to design effective remedies, it is
useful to distinguish among three types of failures that impede financial-market
functioning.

First, there are market failures, which occur when, for example, investors display
herd behavior, information asymmetries exist, or the structure of incentives for
investment managers encourages excessive risk-taking. Second, there are policy
failures, which occur when undisciplined macroeconomic policies and inconsistent or
ineffective financial regulatory policies heighten the risks associated with
volatile capital flows.

The third – and currently most problematic – failure is one of national or
international institutions. Domestic monetary policy has become the first and last
line of defense against growth slowdowns and financial panics, enabling policymakers
to avoid pursuing other important, but far more difficult measures. Using monetary
policy to compensate for deficiencies in other policy areas constitutes an
institutional breakdown: monetary policymakers are not necessarily getting it wrong,
but they are constrained by the configuration of other policies.

The inadequacy of the current framework for global governance compounds the problem.
The grim reality is that, with financial markets becoming increasingly
interconnected, monetary-policy measures taken by any of the major economies have
international spillover effects. An effective governance mechanism or reliable
institution is needed to help emerging markets cope with these effects.

The lack of effective global economic governance has important implications for
capital flows. Emerging-market policymakers believe that they lack recourse to
safety nets that would cushion the impact of volatile flows. Their efforts to
“self-insure,” by, say, building up their foreign-exchange reserves, perpetuate
global economic imbalances.

So how can policymakers address these failures? There has been some progress at the
international level on regulatory reforms aimed at addressing market failures,
though such efforts have been limited by strident resistance from financial
institutions.

Solutions for policy failures are not difficult to discern. Flexible currencies,
more transparent monetary frameworks, and sound long-term fiscal policies can serve
as buffers against capital-flow volatility. Moreover, the functioning of
emerging-economy financial markets should be improved, with policies aimed at
institutional development and improved regulatory capacity. While the right policies
cannot eliminate risk, they can ameliorate the cost-benefit tradeoff from capital
flows.

Fixing institutional failures is the most important – and the most difficult – step.
Successful reform requires, first and foremost, finding the right mix of domestic
policies. In the advanced economies, in particular, a sharper focus on long-term
debt reduction, rather than short-term fiscal austerity, is needed, along with
structural reforms to labor, product, or financial markets, depending on the
country.

In many of the troubled emerging economies, however, monetary policy has shouldered
the burden of controlling inflation, managing the local currency’s value, and
supporting growth. This balancing act is difficult to maintain, leaving these
economies vulnerable when the external environment turns unfavorable.

In India, for example, increasing productivity and long-term growth require fiscal
discipline and a raft of financial- and labor-market reforms. But the central bank
is being asked to do all the heavy lifting. In other emerging markets, too, the main
challenge is to ensure that all macroeconomic and structural policies advance common
goals.

At the same time, the governance structure of multilateral institutions like the
International Monetary Fund must be reformed, in order to bolster their legitimacy
in emerging markets. Otherwise, these institutions will remain ineffective in
confronting collective problems related to macroeconomic-policy spillovers, and in
providing insurance against crises.

Policymakers in advanced and emerging countries alike should focus on the underlying
failures that destabilize their economies and impede growth, rather than trying to
treat the symptoms by manipulating monetary policy or capital controls. Unless they
are supported by strong institutional structures at all levels, such measures will
prove futile in managing capital flows.

Eswar Prasad is Professor of Economics at Cornell University and a senior fellow
at the Brookings Institution.

Project Syndicate, 2013.

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