Todays capital flow cycle is in the spirit of other
cycles, though each cycle has its own characteristics. This
cycle works on the assumption that interest rates in the
advanced economies - and the signals made by the European
Central Bank and the US Federal Reserve confirm this
will remain low or negative for some time ahead. This
assumption adds fuel to the fire.
In some respects, this is quite an old story since a search
for yield is turning investors to emerging markets. Moreover,
an extended period of stable low interest rates in advanced
economies has been accompanied by a terms-of-trade boom for
commodity exporters in Latin America.
Cycles, by definition, go up and down. This cycle continued
from the spring of 2009, and therein lies the danger: markets
might come to the same conclusion that this time is different
and treat the inflow of capital as a permanent feature of the
brave new world. In other words, its déjà
As the capital cycle matures, over-valuation of currencies
and domestic credit booms are two signs to watch. Nevertheless,
many of the economies in the region are enjoying strong
fundamentals: strong terms-of-trade figures, current account
balances, on the whole, in surplus or in modest deficit and net
external debt levels that are generally low by historic
standards, save for eastern Europe. The absence of sizeable
current account deficits and the absence of surging external
indebtedness though emerging markets have low debt
thresholds suggests there are defences.
As the capital cycle matures, over-valuation of
currencies and domestic credit booms are two signs to
In terms of the potential for a reversal, I dont think
it will come with interest rate hikes similar to the market
contagion caused by [former US Fed governor Paul] Volkers
shock rise in interest rates from 1979.
However, a big unknown is whether China will continue to
grow rapidly in the coming years. Emerging markets would be
singing a different song if growth prospects were grim in China
since commodity prices would soften dramatically.
Emerging markets weathered the storm the fall of 2008 well
since output snapped back. But the fundamentals are not the
same as 2007: currencies have appreciated, domestic credit has
expanded and asset prices have risen.
Yet there is little discrimination by investors between the
fundamentals in 2007 and today. Moreover, emerging capital
markets remain relatively illiquid and in periods of stress you
have a high premium on liquidity. That has not changed
dramatically and a lot of assets that we thought were
liquid have turned out to be less so.
Financial globalisation has actually been backtracking since
the 2007 crisis began. Over the past five years, some advanced
economies have been shut out of credit markets, while emerging
markets have been erecting macro-prudential and capital control
Public and private net external liabilities are low by
historic standards and that should be a sign of comfort. But we
need to look at the issue of international reserves of emerging
market countries and look at the gross versus the net
Countries intervene in currency markets by accumulating
foreign exchange reserves but when they sterilize this they do
so by issuing domestic debt. But these domestic debt
liabilities are often not included in government debt
statistics. Thats an issue that I am worried about since
central banks are the ones issuing the IOUs.
These domestic debt burdens have characteristics that
resemble external debt since they are held by non-residents at
high market rates. A quick sell-off in domestic debt holdings
would really represent a claim against the countrys
foreign exchange reserves.
On a lot of the traditional indicators, one can see reasons
to believe that vulnerabilities are limited. But the old issue
of hidden debts is an issue for Brazil and China
since domestic debt is not accounted for. In China, debt is
unaccounted for at the state and province level. In Brazil,
domestic debt levels have increased dramatically given the
sterilization efforts from foreign exchange interventions. It
is very evident that Brazil has over-valuation problems. Things
are expensive and asset prices have risen dramatically. We have
to be very cognizant of the risks and not be blinded by
traditional indicators on external indebtedness.
There is a huge variation across many economies. Chileans
react very conservatively and save the proceeds of the capital
flow bonanza. Argentina and Venezuela, meanwhile, are in a
league of their own. I do worry very much about the fiscal
issue, especially in Brazil.
As the cycle persists, politicians might begin to take for
granted that capital inflows and a booming terms-of-trade
position are permanent features of the brave new world.
Historically-speaking, when that happens, dangerously
pro-cyclical policies kick in. Pro-cyclicality is importantly
tied to terms-of-trade shocks. And I think I have seen this
Professor Reinhart is the Dennis Weatherstone Senior Fellow
at the Peterson Institute for International Economics.