Guest post by Joseph Joyce
Morality Tales and Capital Flows
When the Federal Reserve finally raises its interest rate target, it will be one of the most widely anticipated policy moves since the Fed responded to the global financial crisis. The impact on emerging markets, which have already begun to see reversals of the inflows of capital they received when yields in the U.S. were depressed, has been discussed and analyzed in depth. But the morality tale of errant policymakers being punished for their transgressions may place too much responsibility for downturns on the emerging markets and not enough on the volatile capital flows that can overwhelm their financial markets.
Capital outflows—particularly those large outflows known as “sudden stopsâ€â€”are often attributed to weak economic “fundamentals,†such as rising fiscal deficits and public debt, and anemic growth rates. Concerns about such flows resulted in the “taper tantrums†of 2013 when then-Federal Reserve Chair Ben Bernanke stated that the Fed would reduce its purchases of assets through its Quantitative Easing program once the domestic employment situation improved. The “fragile five†of Brazil, India, Indonesia, South Africa and Turkey suffered large declines in currency values and domestic asset prices. Their current account deficits and low growth rates were blamed for their vulnerability to capital outflows. There have been subsequent updates of conditions in these countries, with India now seen as in stronger shape because of a declining current account deficit and lower inflation rate, whereas Brazil’s situation has deteriorated for the opposite reasons.
But this assignment of blame is too simplistic. Barry Eichengreen of UC-Berkeley and Poonam Gupta of the World Bank investigated conditions in the emerging markets after Bernanke’s announcement. The countries with largest current account deficits also recorded the largest combination of currency depreciations, reserve losses, and stock market declines. But Eichengreen and Gupta found little evidence that countries with stronger policy fundamentals escaped foreign sector instability. On the other hand, the size of their financial markets as measured by capital inflows in the period before 2013 did contribute to the adverse response to Bernanke’s statement. The co-authors interpreted this result as showing that foreign investors withdrew funds from the financial markets where they could most easily sell assets.
