Need for a pre-emp­tive ac­tion on cap­i­tal flows

The Pak Banker - - OPINION - Joseph E. Stiglitz

DE­VEL­OP­ING coun­tries are brac­ing for a ma­jor slow­down this year. Ac­cord­ing to the UN re­port World Eco­nomic Sit­u­a­tion and Prospects 2016, their growth will av­er­age only 3.8 per cent this year - the low­est rate since the global fi­nan­cial cri­sis in 2009 and matched in this cen­tury only by the re­ces­sion­ary year of 2001. And what is im­por­tant to bear in mind is that the slow­down in China and the deep re­ces­sions in the Rus­sian Fed­er­a­tion and Brazil only ex­plain part of the broad fall-off in growth.

True, fall­ing de­mand for nat­u­ral re­sources in China (which ac­counts for nearly half of global de­mand for base me­tals) has had a lot to do with the sharp de­clines in th­ese prices, which have hit many de­vel­op­ing and emerg­ing economies in Latin Amer­ica and Africa hard. In­deed, the UN re­port lists 29 economies that are likely to be badly af­fected by China's slow­down. And the col­lapse of oil prices by more than 60 per cent since July 2014 has un­der­mined the growth prospects of oil ex­porters. The real worry, how­ever, is not just fall­ing com­mod­ity prices, but also mas­sive cap­i­tal out­flows. Dur­ing 2009-14, de­vel­op­ing coun­tries col­lec­tively re­ceived a net cap­i­tal in­flow of $2.2 tril­lion, partly ow­ing to quan­ti­ta­tive eas­ing in ad­vanced economies, which pushed in­ter­est rates there to near zero.

The search for higher yields drove in­vestors and spec­u­la­tors to de­vel­op­ing coun­tries, where the in­flows in­creased lev­er­age, propped up equity prices, and in some cases sup­ported a com­mod­ity price boom. Mar­ket cap­i­tal­i­sa­tion in the Mum­bai, Jo­han­nes­burg, São Paulo, and Shang­hai stock ex­changes, for ex­am­ple, nearly tripled in the years fol­low­ing the fi­nan­cial cri­sis. Equity mar­kets in other de­vel­op­ing coun­tries also wit­nessed sim­i­lar dra­matic in­creases dur­ing this pe­riod.

But the cap­i­tal flows are now re­vers­ing, turn­ing neg­a­tive for the first time since 2006, with net out­flows from de­vel­op­ing coun­tries in 2015 ex­ceed­ing $600 bil­lion - more than onequar­ter of the in­flows they re­ceived dur­ing the pre­vi­ous six years. The largest out­flows have been through bank­ing chan­nels, with in­ter­na­tional banks re­duc­ing their gross credit ex­po­sures to de­vel­op­ing coun­tries by more than $800 bil­lion in 2015. Cap­i­tal out­flows of this mag­ni­tude are likely to have myr­iad ef­fects: dry­ing up liq­uid­ity, in­creas­ing the costs of bor­row­ing and debt ser­vice, weak­en­ing cur­ren­cies, de­plet­ing re­serves, and lead­ing to de­creases in equity and other as­set prices.

There will be large knock-on ef­fects on the real econ­omy, in­clud­ing se­vere dam­age to de­vel­op­ing coun­tries' growth prospects. This is not the first time that de­vel­op­ing coun­tries have faced the chal­lenges of man­ag­ing pro-cycli­cal hot cap­i­tal, but the mag­ni­tudes this time are over­whelm­ing. Dur­ing the Asian fi­nan­cial cri­sis, net out­flows from the East Asian economies were only $12 bil­lion in 1997. Of course, the East Asian economies to­day are bet­ter able to with­stand such mas­sive out­flows, given their ac­cu­mu­la­tion of in­ter­na­tional re­serves since the fi­nan­cial cri­sis in 1997. In­deed, the global stock of re­serves has more than tripled since the Asian fi­nan­cial cri­sis.

China, for ex­am­ple, used nearly $500 bil­lion of its re­serves in 2015 to fight cap­i­tal out­flows and pre­vent the ren­minbi's sharp de­pre­ci­a­tion; but it still has more than $3 tril­lion in re­serves. The stock­pile of re­serves may partly ex­plain why huge out­flows have not trig­gered a full-blown fi­nan­cial cri­sis in de­vel­op­ing coun­tries. But not all coun­tries are so for­tu­nate to have a large arse­nal.

Once again, ad­vo­cates of free mo­bil­ity for desta­bil­is­ing short-term cap­i­tal flows are be­ing proven wrong. Many emerg­ing mar­kets recog­nised the dan­gers and tried to re­duce cap­i­tal in­flows. South Korea, for ex­am­ple, has been us­ing a se­ries of macro­pru­den­tial mea­sures since 2010, aimed at mod­er­at­ing pro­cycli­cal cross-bor­der bank­ing-sec­tor li­a­bil­i­ties. The mea­sures taken were only par­tially suc­cess­ful. The ques­tion is, what should they do now? Cor­po­rate sec­tors in de­vel­op­ing coun­tries, hav­ing in­creased their lev­er­age with cap­i­tal in­flows dur­ing the post-2008 pe­riod, are par­tic­u­larly vul­ner­a­ble. Cap­i­tal out­flows will ad­versely af­fect their equity prices, push up their debt-to-equity ra­tios, and in­crease the like­li­hood of de­faults.

The prob­lem is es­pe­cially se­vere in com­mod­ity-ex­port­ing de­vel­op­ing economies, where firms bor­rowed ex­ten­sively, ex­pect­ing high com­mod­ity prices to per­sist. Many de­vel­op­ing-coun­try gov­ern­ments failed to learn the les­son of ear­lier crises, which should have prompted reg­u­la­tions and taxes re­strict­ing and dis­cour­ag­ing for­eign-cur­rency ex­po­sures. Now gov­ern­ments need to take quick ac­tion to avoid be­com­ing li­able for th­ese ex­po­sures. Ex­pe­dited debtor-friendly bank­ruptcy pro­ce­dures could en­sure quick re­struc­tur­ing and pro­vide a frame­work for rene­go­ti­at­ing debts.

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