Finance chiefs warn on capital flows reversal

22/03/2010 | Greg Brosnan

Surge in developed world debt issuance and interest rates threaten emerging markets, policymakers caution

The risk is growing of a sudden reversal in capital flows to emerging markets that would severely punish economies without sound fiscal policies, policymakers warned yesterday.

Mexico’s central bank governor Agustin Carstens said a surge in developed world debt issuance and rising interest rates could torpedo recent investor enthusiasm for emerging markets.

“The bottom line for emerging markets – and that is something that worries me the most – is that the possibility of having sudden stops [in capital flows] is increasing pretty much for everybody,” Carstens said in Cancun.

He added that although Latin economies are “able to place long term debt and the market is receptive”, the likelihood of increased debt issues among large deficit industrialised countries could undermine emerging markets access to funds.

“Appetite for more risk in terms of EM might reduce. We might not have access to such long term financing,” Carstens added. “The tolerance of markets for fiscal [laxity] is not there.”

Ultra-easy US monetary policy and the cheap cost of dollar funding has led to a surge in emerging market asset prices, fuelled by the so-called dollar carry trade – where investors borrow in dollars and invest the money in high-yielding assets of another country.

Institute of International Finance (IIF) managing director Charles Dallara urged caution over the direction of US monetary policy. “The Fed will probably need to tighten monetary policy sooner than markets expect today. When the [US dollar] carry trade reverses, governments and central banks will have to be very careful.”

Former Mexican central banker Guillermo Ortiz echoed these concerns, urging policymakers to look to lessons from previous crises.

“There are worries about the carry trade,” Ortiz told Emerging Markets. “In the past when the US has reined in loose monetary policy, this entry of [capital] flows reverses, and sometime dramatically, and things start to go the other way. Volatility and risk aversion increase and countries with a weak external positions can end up in trouble.”

Lack of market confidence in the sustainability of public finances has historically conspired to create havoc in Latin America.

Ortiz added that Latin governments must “take advantage of these better times” to “continue the process of fiscal consolidation, to keep bringing down debt to GDP levels, continuing being more efficient in our economies, pushing through badly needed structural reforms.”

Philip Suttle, chief economist at the IIF, said: “We are now in the fourth bull run for emerging markets – and it’s important to note that the last three cycles ended in an a crisis.” He pointed to the “real threat of crowding out of emerging market borrowers in international markets by high G7 government spending”.

Former Brazilian finance minister Antonio Palocci called on the US spell out its exit strategy to avoid any adverse shocks to the global economy.

“There will be an impact all over the world but it is important that Latin American countries are duly informed,” he told Emerging Markets. “So far we have not seen any exit strategy from the US, I have got the impression that it does not exist.”

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