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Environment

Opinion: Capital flows bring hidden risks to emerging economies

Guest commentator Ulrich Volz of the German Development Institute analyzes risks stemming from the flow of money from wealthy to developing economies. He sees a solution in capital controls and currency revaluations.

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The money is flowing again. After the withdrawal of massive sums by banks and other financial investors from emerging economies following the Lehman crash in September 2008, investment has been strong since mid-2009.

The Institute of International Finance (IIF) in Washington estimates that $908 billion (610 billion euros) in private net capital flowed to emerging economies in 2010, 50 percent higher than in 2009. It anticipates a further rise in private capital movements to emerging economies to $960 billion in 2011 and just over one trillion dollars in 2012.

While most industrialised countries continue to struggle with the aftermath of the global financial crisis, the economies of many developing and emerging countries are experiencing strong growth.

Good prospects in developing nations are attracting investors, as are the strong fundamental data on most emerging economies, positive interest rate differentials and expected revaluations of their currencies. The still expansive monetary policies pursued by most industrialised countries are, moreover, resulting in high global liquidity, which is flowing not only to the international oil, raw materials and food markets but also to the emerging economies.

A sign says Money Changer outside of a rural currency exchange facility

Dr. Volz points sees three big problem areas in terms of cash flow to developing countries

Three central risks

These capital flows from wealthier nations pose a challenge for the emerging economies and entail big risks - even of financial crises.

First, there is a danger of a "sudden stop" of the capital flows or even of a rapid withdrawal of portfolio investments, which happened during the global financial crisis in 2008. IMF studies show that capital flows have become more volatile in recent decades - more so for emerging economies than for industrialised countries.

Current financial flows to emerging economies are dominated by portfolio investments in bond markets, which have historically been particularly volatile. In contrast, direct investments, which tend to be long-term in nature and to which the greatest development effects are generally ascribed, are again on the decline.

A second problem is that international capital flows may help bubbles to form. In many emerging economies credit allocation fuelled by low real interest rates has already led to a boom in capital markets and the real estate sector. Further external capital flows may encourage the tendency for bubbles to form.

The recent experience of such crisis-hit countries as the US, Ireland and Spain, whose investment booms were similarly fuelled by external investments not so long ago, should cause concern.

And thirdly, capital flows increase inflationary pressure in the emerging economies, especially when they are bracing themselves against a revaluation of their currencies, as is currently the case. Intervention in the foreign exchange market aimed at preventing or weakening currency revaluations increases the money supply and complicates the central bank's monetary policy.

The rise in prices on the international raw materials and food markets has already led to a significant increase in inflationary pressure in emerging economies. For some time now many of these countries, including China and India, have been wrestling with growing rates of inflation and especially with rising food prices.

A financial chart showing decline

Developing economies must avoid financial bubbles and the hazards they bring

Policy options

Emerging economies have a number of policy options for counteracting inflationary pressure and the formation of bubbles on financial and real estate markets. They can, for example, pursue stricter monetary and fiscal policies or impose tighter rules on the financial sector.

The problem with a more restrictive monetary policy, however, is that higher interest rates would attract further capital, creating even greater pressure for currency revaluation. Although revaluation would ease domestic inflationary pressure, international purchasing power would be increased, making imports cheaper. But most emerging economies are afraid that revaluation will make their export industries less competitive, especially as China continues to peg its currency closely to the dollar.

Many emerging economies, such as Brazil, Indonesia, South Korea, Thailand and Turkey, have therefore been trying in recent months to limit the inflow of foreign capital with various kinds of capital controls. In a welcome development, the IMF - long a fierce critic of such controls - has advocated their use under certain conditions in a recent report on the management of capital inflows.

The 2011 BRICS summit

The 2011 BRICS summit was held in Sanya, Hainan province, China on April 14

Don't fear currency revaluation

Emerging economies should also not refrain from resisting an orderly revaluation of their currencies. To maintain relative competitiveness amongst themselves, major emerging economies, such as Brazil, Russia, India, China and South Africa (BRICS), might agree on a coordinated revaluation, which would also give other developing and emerging countries more breathing space for a revaluation.

At the request of the Chinese host, exchange rate policy was omitted from the agenda for the latest BRICS summit meeting on April 14, 2011. But it is in their common interest for the subject to appear at the top of the BRICS agenda as soon as possible.

All of the participants in the global economy depend on the major economic nations - which now include the emerging economies - to act cooperatively. Finding cooperative solutions beyond the limits of short-term national interests is clearly becoming even more complicated in this new, multipolar global economy.

The author, Dr. Ulrich Volz, is an economist with the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE), one of the leading think tanks for development policy worldwide. DIE draws together the knowledge of development research available globally and dedicates its work to key issues facing the future of development policy.

Author: Ulrich Volz
Editor: Greg Wiser

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