CARMEN REINHART: The lessons of history

18/03/2012 | Sid Verma

Policymakers must beware of capital inflows, says Carmen Reinhart. This time is not different

Today’s 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, it’s déjà vu.

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 watch”

In terms of the potential for a reversal, I don’t think it will come with interest rate hikes similar to the market contagion caused by [former US Fed governor Paul] Volker’s 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 measures.

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 holdings figure.

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. That’s 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 country’s 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 movie before.


Professor Reinhart is the Dennis Weatherstone Senior Fellow at the Peterson Institute for International Economics.

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