Uncertainties remain. Asset and property price bubbles need to be watched for. When the Fed begins to wind QE3 down, which could be as early as October, interest rates in emerging-market economies are likely to increase (again). This means debt servicing costs will increase and this will make policy choices more difficult and reforms more costly.
When the Federal Reserve set out its preferred timeline for tapering QE3, the yield on the US Treasury note climbed 60 basis points and emerging-market assets were sold off. Within a month of the Fed’s communiqué on 22 May, emerging-market equity and bond funds recorded a combined net outflow of US$25 billion. This mass movement demands an immediate policy response. The countries hit hardest by the capital flight include India, Indonesia, Brazil, Turkey and South Africa. Why are investors scurrying back to the United States for just a slight increase in yield? One explanation is that investors prefer to invest in their home countries, where more information is available — the ‘home bias’ argument.
Whatever the reason, the effects of capital flight on some emerging economies — a deteriorating balance of payments and foreign exchange reserves, currency depreciation, increased interest rates and bond yields, and a plummeting stock market — are predictable. But many economies seem unprepared, or rather, are missing their opportunities to reform in the ‘good times’. Some countries have even come to depend on huge capital inflows to fund their current account deficit, which may be the product of long-term structural weaknesses. Instead of implementing necessary structural reforms, these countries claimed that the high growth and macroeconomic stability they enjoyed after the 2008–09 great recession were due to good economic management. But the real causes of their success —including cheap cash injections from some of advanced countries — were mere accidents of fortune which may disappear at any time.
As capital is sucked out of emerging economies they will realise that structural reform is indispensable to financial and monetary stability. In particular, investors will shy away from countries with an unsustainable fiscal policy — for example, one directed to consumptive expenditure instead of productive investment. Poor-quality fiscal settings increase the country’s risk premium, the sovereign bond yield and the cost of borrowing. This will make policy choices become difficult partly because it will become more expensive to conduct reforms. These problems could cause structural weaknesses and, eventually, financial and monetary instability. Any structural issues that could weigh down the balance of payments, such as a widening current or capital account deficit, must be addressed.
More broadly, capital flight from emerging markets in recent months shows that global monetary coordination remains in its infancy. This year, the St Petersburg G20 Summit aims to coordinate monetary policies and manage the way changes in the monetary policies of large economies — especially the United States, Europe, China and Japan — affect emerging economies.
This is a welcome development, but how this coordination of monetary policies will be achieved is unclear. Even Ben Bernanke, who has been talking about the importance of communicating monetary policies since at least in 2004, stated recently that the complexity of the stimulus program made it difficult to predict future policy: ‘We are dealing with tools that are less familiar and harder to communicate about’.
A lack of monetary coordination combined with the financial market’s sentiment that the world monetary situation is unpredictable is causing more volatility. Moreover, Information theory tells us that revealing more information could create multiplicity of equilibria and, depending on some factors such as sensitivity of information and the fundamentals of corresponding countries, more or too much transparency could result in worse equilibrium outcomes.
Central banks around the world are experimenting with aggressive, unconventional monetary policies to contain the consequences wrought by recent financial ‘innovations’. The problem is that these experiments may themselves lead to unintended consequences. Financial innovations and the interlinked relationships between different countries’ monetary policies can bring benefits. But they also bring profound risks, which the global economic infrastructure is unable yet to contain. For example, many Asian countries are still reluctant to borrow from the IMF and other IMF-linked regional financial arrangements, such as the Chiang Mai Initiative Multilateralization. There is no readily available regional or global financial safety net in place in the region, unless the IMF completes its governance reforms.
Because of this, emerging economies need to be ready with international reserve buffers. Bilateral swap agreements will help provide liquidity cushions, as will local investment in better quality assets, in case foreign investors pull out en masse.
The credibility of the G20 will be under threat if it does not start building a genuine global economic system to contain all possible risks, regardless of how complex such an undertaking is. It will be a little too late if the global community continues to procrastinate on financial sector and global economic governance reforms that we know to be necessary.
Meanwhile, emerging-market economies must not miss the opportunity to reform provided by the Fed’s delays on tapering QE3.
Maria Monica Wihardja is a former lecturer at the Department of Economics, University of Indonesia, and a former researcher at the Centre for Strategic and International Studies, Jakarta. She is also Associate Editor at the East Asia Forum Indonesia desk.