The dollar drag

Written by Alok Sheel | Updated: Feb 7 2014, 10:04am hrs
The current global debate on monetary policy is centred on whether it should target financial stability in addition to the domestic business cycle. With relatively tight regulation of financial markets, where present concerns are more developmental than regulatory, the counterpart debate in EMEs centres is on reconciling two widely held economic policy formulations, namely the Mundell-Fleming's Impossible Trinity and the Taylor Rule. The problem has become all the more compelling in a rapidly globalising world where large, volatile capital flows lead to misaligned and volatile exchange rates that threaten macroeconomic stability. The recent currency crisis which constrained Brazil, Turkey, Indonesia and India into tightening policy rates amidst collapsing growth, makes the case for reconciling the Impossible Trinity with the Taylor Rule of monetary policy all the more compelling.

Ceteris paribus, if a country runs a current account deficit (CAD), its currency should depreciate against those of its trading partners. There are, however, two major circumstances, one emanating from the current account (the 'Dutch disease syndrome'), and the other from the capital account (southern cone syndrome) under which this reasoning does not hold. The latter is more germane here because large and volatile capital inflows into EMEs have become a far more frequent phenomenon as a result of loosening of financial regulation, innovation, globalisation and monetary policy spillovers. Cross-border flows of capital to EMEs have increased manifold since the 70s following the oil price hikes and export-led growth strategies adopted by several East Asian economies. The first manifestation of this syndrome in developing economies was the wave of financial liberalisation which led to a debt-fuelled recycling of petrodollars by American banks in the southern cone in Latin America.

While large capital inflows can sustain large CADs for some time, over the medium- to long-run, they tend to magnify external imbalances and lay the ground for external payments crises. There are also large capital flows into countries running account surpluses. Once the capital surge abates, and particularly in the event of a sudden stop, there is a likelihood of a sudden, rapid and accelerated correction in exchange rates, with the nominal exchange rate depreciating sharply, and the Real Effective Exchange Rate (REER) overshooting its neutral (long-term fundamental) rate. This can cause short-term macroeconomic instability, such as higher inflation, a loss in international confidence and credit downgrade that could compound the reversal in capital flows and even precipitate an external payments crisis.

What pushes capital into EMEs, and what triggers the sudden stops While fundamentals and the prospects of higher returns are certainly contributory factors, it is now becoming increasingly clear that the major factor driving flows in and out of EMEs has little to do with the fundamentals of recipient countries but yields in the source countriesthe US, in particular, which has the biggest and deepest financial market in the world. While the asymmetry in flowsparticularly outflowscan to some extent be explained by differing fundamentals, the inflows and the outflows, seem to come in waves, across a wide swathe of countries.

Large global imbalances themselves should not result in destabilising flows. They are nothing new, and capital account flows have traditionally been simply the counterpart of current account balances. However, the cocktail of loosening of financial regulation, innovation, globalisation and the extant international monetary system have combined to open up a growing gap between gross capital flows and net flows that reflect current account balances. It is not entirely coincidental that the capital stop in the southern cone in the early-80s, in East Asia in the late-90s, and across a broad sweep of EMEs since May 2013, followed a tightening of monetary policy by the United States Federal Reserve. With the integration of financial markets and globalisation, the spillovers of US Fed monetary policies are only increasing because of the overarching dominance of the dollar in the international monetary system. Fed policies, therefore, hugely determine the direction and velocity of cross border capital flows. No other central bank comes even close to exercising this kind of influence, even within its own borders.

Over the years, the dollar has effectively become the global reserve currency. As a result, US monetary policy has a determining influence on the direction and quantum of global capital flows. This, in effect, gives the issuer of the global reserve currency the flexibility to soak up capital when it needs it most, and to export it out when it suffers from excessive domestic liquidity. Through this mechanism, the US can fund literally unlimited amounts of external and internal deficits without being penalised by the markets as happens in the case of other countries. Open capital accounts, espoused by the IMF, only facilitates this funding and magnifies the exorbitant privilege of the dollar.

It has long been argued, from the days of John Maynard Keynes, that the extant international monetary system has a structural flaw in that it lacks a mechanism, market based or otherwise, to induce surplus countries to adjust. This can lead to the persistence of large external imbalances that are potentially destabilising. Recent history however indicates that this is not entirely correct, as there is also little pressure on countries with reserve currencies, and especially the global reserve currency, to adjust even when they run large CADs, on account of the large external demand for their currencies. The latter is also consistent with the Triffin Dilemma, by which the reserve currency issuer is expected to run larger and larger CADs to meet the growing needs of global liquidity. This is manifestly not true in the cases of currencies like the Japanese yen and the Swiss franc. Both countries have run current account surpluses over the last decade and a half. Similarly, even while its currency was becoming important in the composition of the global portfolio of reserve currencies, the euro was running a roughly balanced current account position with the rest of the world. This is because it is really the dollar that is accepted as the de facto global reserve currency by markets, even though the IMF may have classified other currencies also as reserves.

In effect, the US Federal Reserve acts as the global central bank. Policy easing by the US Federal reserve, both prior to and following the global financial crisis, led to a surge in capital inflows into emerging markets, appreciating their currencies. There were intervening periods of sudden stops, as US monetary policy changed course, resulting in sharp currency depreciation, sudden stops and external payments crises. This happened in the 80s in Latin America, in the 90s in East Asia, and is now affecting EMEs globally. International financial markets in EMEs appear to respond more to US Fed actions than to domestic economic fundamentals.

According to Impossible Trinity, a country can have only two of the following three: Fixed exchange rate, monetary independence and free capital flows. A free monetary policy means that it is free to respond to the domestic business cycle. The Taylor Rule prescribes a rule-boundas opposed to discretionarymonetary policy by which the central bank adjusts its short-term policy rate based on a mathematical formula using differentials between a countrys potential GDP and actual GDP, and inflation target and actual inflation. The Taylor Rule and its variants are now used by almost all advanced-country central banks. The author of the rule, John B Taylor of Stanford University, is of the view that it is relevant for developing country central banks also. Many developing countries have indeed started using the Taylor Rule.

In advanced economies, the Taylor Rule responds to the domestic business cycle. Monetary policy in developing countries, on the other hand, is constrained to respond to the external financial cycle, which distorts the application of the Taylor Rule. Thus, if domestic growth concerns warrant low interest rates, a sudden stop in capital inflows may induce them to keep interest rates unduly high to attract foreign capital, thereby magnifying the downturn in the business cycle. In other words, they end up trying to negotiate the Impossible Trinity. Raising interest rates at such times rarely works because the stops are frequently not country-specific, and in any case, foreign investors are more concerned about capital losses than higher interest income.

Domestic debt in EMEs is backstopped by their central banks. External deficits denominated in international reserve currencies are not. The dependence on market support makes them susceptible to external payments crises in the event of market revolt if deficits are perceived to be excessive and unsustainable.

This threat of external payments crisis compels developing countries to frequently use monetary policy for managing external imbalances, in addition to managing the domestic business cycle. They need separate instruments, as part of a consistent policy framework, to target the external financial cycle so that their central banks to retain monetary independence.

The author is secretary, Economic Advisory Council to the Prime Minister. Views are personal