Latin America must beef up financial regulation, cut spending and make currencies more flexible, to combat the threat of asset bubbles and economic overheating, the IMF has warned.
There is obviously the risk that markets get ahead of themselves, Nicolas Eyzaguirre, director of the western hemisphere department at the IMF, said. The unprecedented situation requires new frameworks and a new response, he told Emerging Markets in an interview.
Demand for emerging market risk has meant that the so called impossible trinity the hypothesis that its impossible to manage exchange rates, control inflation and allow the free movement of capital at the same time has returned with a vengeance in Latin America.
Raising interest rates to curb domestic credit supply risks attracting more capital inflows, as foreign investors rush for yield amid ultra-low interest rates in mature markets, Eyzaguirre said. Fiscal policy should be tightened but it can not do all the work, he argued.
He said countries should adopt flexible exchange rates, as undervalued currencies tend to trigger a surge in foreign currency debt by domestic companies and attract more capital.
Strong prudential measures in banking are needed, Eyzaguirre said, but many countries do not have those frameworks in place. As a result, we can see room for capital controls even though they are more blunt in nature.
Brazil and Colombia have imposed restrictions on foreign capital inflows in the past year, followed by emerging market counterparts Taiwan, Indonesia and South Korea.
Eyzaguirre said valuations in Brazilian markets are not in bubble territory, but that the risk of overheating of the economy looms large, as a result of foreign investment and strong commodity prices. You need to pay attention, so that the economy does not grow faster than the current structure of production can support.
Henrique Meirelles, president of the Brazilian central bank, said in Cancun: The first line of defence [against bubbles] is prudential rules. And we are on top of that. He was referring to new regulations that force companies to disclose derivative and foreign currency debt exposures.
Eyzaguirre said the policy challenge of ensuring stability given the required co-ordination between fiscal, monetary and banking authorities was a very new situation and in many ways a greater challenge than the global crisis.