Mercantilism, or the belief that the strength of nations hinged on accumulating gold through persistent trade surpluses, was the prevailing economic orthodoxy just before the dawn of the golden age of classical economics. According to the classical economists, however, although trade could make nations wealthy on account of its ability to promote efficiency?through the theory of comparative advantage?trade surpluses were not an end in themselves. They took a neutral position on whether international trade or domestic demand should be the engine of growth.
Classical economists postulated that as countries developed, the rate of return on capital declined, leading capital to flow to developing countries. In the pre-1914 phase of globalisation, this is exactly what happened. That the bulk of capital flows subsequently were between developed countries did not disprove these assumptions: the size of developing economies was just not big enough to absorb such large flows. On balance, there was, as predicted, net outflow of capital from the developed to the developing world. In the post-colonial period, this was initially mostly in the form of debt, though more recently equity flows have become predominant.
Trade deficit was the mechanism through which capital flowed to developing countries. Developing countries were expected to run trade deficits, which would be funded through external capital flows that supplemented domestic savings to enhance growth.
This formulation was rendered increasingly complex on account of changes in the international monetary system that classical economists could not have anticipated. Neo-classical economists have, however, fleshed in the details. If a developing country ran trade surpluses, ceteris paribus, its currency would appreciate, reducing its export competitiveness and transferring purchasing power and demand from external to domestic residents. The external account would consequently move closer to balance.
But what if the domestic currency was not allowed to appreciate by the central bank? Developing countries today are piling up huge reserves through a combination of persistent trade surpluses and managed floats. These reserves constitute net capital outflows from developing countries, contrary to the formulations of classical economists. These flows finance consumption in the US, whose trade deficit is equivalent to the combined trade surplus of the rest of the world. Why would developing countries prefer overseas demand over domestic demand as their engine of growth? One reason could be the size of the domestic economy relative to the world economy.
Many East Asian economies that started industrialising from the 1970s using international trade as their growth engine were small-sized economies. But why continental economies like China and India should show a similar preference is not entirely clear. Are we seeing a return to mercantilism, with hard currency reserves taking the place of gold? This mercantilist logic enables developing countries like India and China to register high rates of growth despite muted domestic demand on account of low per capita incomes and pervasive poverty.
But the new mercantilism has costs beyond depressing local demand. Large-scale hard currency acquisitions release huge amounts of equivalent local currency in the domestic market that can be inflationary if the absorptive capacity of the economy does not increase proportionately. This hazard can be neutralized through ?sterilisation?: the central bank buys back the excess local currency through bond issues. This, in turn, can have a huge negative fiscal impact, since the interest paid out on domestic bond issues is significantly higher than what the central bank earns on its foreign currency assets that are typically parked in low-yielding risk-free hard currency sovereign bonds.
Large-scale sterilisation operations also put an upward pressure on interest rates that can both compromise growth and attract even more capital inflows. Continued appreciation of the domestic currency can also lead to capital losses in the central bank?s accumulated stock of hard currency assets.
While several reasons have been attributed to the recent emergence of sovereign wealth funds, that invest part of the sovereign reserves in higher yielding but riskier equities, they should inter alia be seen as a response to the fiscal dilemma associated with sterilisation on an epic scale which is a logical corollary of the new mercantilism.
?The author is a civil servant. These are his personal views