Friday, August 30, 2013

Capital Flows and QE

There is significant discussion among economists and media observers about the growing momentum of capital flows leaving emerging economies particularly in Asia. In recent weeks we have seen a major drop in the values of currencies such as the Indian Rupee and the Indonesia Rupiah.

US Dollar Value of Indonesian Rupiah

To some extent this is predictable. Because the US Federal Reserve has signaled a winding down of its latest Quantitative Easing (QE) effort, US interest rates have started to rise. The rise in interest rates indicate an expected increase in the rate of return on funds invested in the US. Therefore, funds will flow from other parts of the world into the US. This is seen in the appreciation of the value of the dollar versus the currencies who might have strengthened during the period when interest rates were near 0 in the US.

US Dollar Value and Indian Rupee

This pattern is reproduced in India, Malaysia and Singapore over the same period. Is there a danger to their economies from the depreciation in their currencies? In the capital outflows? Part of the answer comes from the analysis of the source of the capital inflows in previous years. In today's Financial Times there is an in depth analysis of this question and concludes...

"Mr Lai makes a broader point about Asian foreign exchange reserves as a whole. Between 2008 and 2012, the total accumulated by China, India, Korea, Taiwan, Hong Kong, Singapore, Indonesia, Malaysia, Thailand and The Philippines almost exactly matches the growth in the US Federal Reserve’s balance sheet due to quantitative easing. As he says, the correlation appears very high."

It will take a bit of time to make sure this correlation reveals causality but it does match theory. The flood of cash used to prop up the banks in the US and other advanced economies flowed to emerging economies which had potentially higher rates of return. Unlike the 1990's when that flow represented loans denominated in dollars recent capital flows have been int he form of FDI (Foreign Direct Investment) which might not be so destabilizing unless there is wholesale divestment. So far there is a split in this analysis with Krugman saying it is a natural rebalancing and not much of a problem and others saying a new crisis could be on the horizon.

The issue that comes to mind is whether these countries have the capability of protecting their currency and their capital basis from these runs. Economists hate capital controls and see them as an impediment to further investment and inevitably ineffective. But if the recent depreciations herald a major outflow with consequences (stagflation on a major scale say) then the emerging countries will need to examine these tools to control capital in and out.

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