Capital and Development: Coping with the Carry Trade

Jayati Ghosh

Once again, emerging markets have become the (often unwilling) “beneficiaries” of a surge in private capital flows. Once again, this is not really being used within most receiving economies, since they continue to add to their external reserves. And once again, this is creating additional and often complicated problems of macroeconomic management, with conflicts between different domestic goals.

Some of this renewed capital inflow relates to the perceptions of private investors about better long term economic growth prospects in countries like China, India, Brazil and so on. But much of this is simply what is known as the “carry-trade”, which is essentially the attempt to benefit from different rates of return on assets in different currencies.

This is not a new tendency – for example, in the late 1990s, the Japanese yen carry trade (which was based on interest rate arbitrage) caused significant exchange rate movements that affected its trade partners adversely. Today’s basic source of the carry trade is the US economy. This results from the very loose monetary policy that was part of the stimulus package, with low interest rates, easy credit policies and “quantitative easing” (which is the current euphemism for deficit financing in the form of money creation). These have all provided a significant increase in access to funds at very low nominal interest rates that are actually negative in real terms, because they are well below expected inflation.

As a result, the big players in international capital markets – banks, mutual funds, hedge funds and the like – have renewed risk appetite and are making forays into emerging markets (mostly through portfolio flows) as well as into commodity markets (mostly in the futures markets). In the past one year there has been a near doubling of net private capital flows into emerging markets.

As usual, the money does not flow to countries that really need it. So countries with balance of payments problems and a tight foreign exchange constraint – such as Pakistan or Sri Lanka, for example – are still forced to go to the IMF and undergo strenuous pro-cyclical adjustment measures. Instead, countries that experienced less impact of the global crisis, or recovered relatively quickly, and have good growth prospects and fewer current balance of payments difficulties, are the ones being favoured. Most of the inflows are in the form of portfolio flows that have contributed significantly to pushing up stock market indices.

This is at best a very mixed blessing. Central banks are being forced to intervene to mop up dollars in order to prevent currencies from going up, and are therefore adding to reserves even when this implies substantial seignorage losses because of interest rate differentials. Despite this, currencies of the recipient countries are appreciating rapidly, hitting exports and damaging export-competing production. Most emerging market currencies (other than China, of course) have appreciated significantly against the US dollar since April 2009.

These potentially volatile capital inflows also affect domestic asset markets directly. Asset bubbles in non-tradeable sectors (such as stock markets, real estate and construction), which were already under way because of easy monetary policies in response to the crisis, are getting aggravated, making it more likely that the eventual burst will be more painful.

Some countries are trying to reduce inflationary pressures through increasing interest rates – thus the Reserve Bank of India recently raised short term rates by 25 basis points. But this strategy has two risks: of stifling the recovery, especially for small business, and of increasing the interest rate gaps that provided the impetus for the carry trade in the first place!

So how are emerging markets supposed to cope with the unfortunate current and future effects of this carry trade? It seems quite clear that when such capital inflows can create so many problems, and are not even really being used in the macroeconomic sense, there is a strong case for instruments to control them. Putting constraints on capital inflows was something that only a small minority of countries (most famously Chile) attempted in the 1990s, but recently, they have become slightly more widespread.

Even the IMF appeared to recognise in the middle of this decade that such controls can be necessary and useful as tools of flexible macroeconomic policy. However, it seems to be backtracking now, in its latest publications, as Kevin Gallagher has shown.

Fortunately, since the IMF is less important now in determining policies at least in the successful emerging market economies, there is still scope for them to learn from each other rather than from Washington. But the world economy is much more complicated than it has been for some time, so capital management techniques also need to be more responsive and flexible.

Differential tax rates, as tried in Brazil, may need to be combined with other measures like marginal reserve requirements, limits on forex lending to residents, ceilings on external borrowing, and also adjusted for specific conditions. But without such measures, emerging markets are likely to find that the current recovery brings with it more problems for the future.