If you ever needed evidence of how the contemporary global economy interconnects, just consider the belated international reaction to the realization that the Federal Reserve eventually must end its big expansion of bank reserves known as “quantitative easing.”
Just read this week’s headlines: “Indian rupee hits record low,” “Peru’s central bank offers to sell dollars as sol weakens,” and “Brazil gets whiplash as currency heads the other way — down.”
These are three of the many countries that face economic adjustments as the perceived profitability of investments in their economies declines relative to investing in the United States.
Readers with good memories will recall that just a few years ago, the opposite was true. Low investment returns in the United States, driven by the Fed, were driving money to other countries. Brazil, in particular, complained that this rush of “hot money” was driving up the value of its currency, thus hurting its domestic producers and overall employment by making imports cheap for consumers and Brazil’s exports expensive to foreign buyers. Now the flow is the other way, and they aren’t happy, either.
Let’s start by understanding the links. Investment managers for pension plans, hedge funds and the like have to seek the highest returns that are commensurate with risk. By the time the Fed reduced interest rates to historically low levels in the wake of the financial crisis that unrolled in 2007-2009, the U.S. stock market already had gone to pot. In addition, low interest rates drove down the yields on U.S. corporate and Treasury bonds.
Stock markets and returns on bonds were higher in many other nations, especially those still benefiting from the worldwide boom in commodity prices, which was being driven by China’s demand for imported raw materials and food.
With its position as the world’s second largest exporter of soybeans and iron ore, along with its sales of beef, orange juice and myriad other products, Brazil was doing well. Peru has a less diverse economy, but its mines produce copper, lead, bismuth, vanadium and many other metals, all in strong demand.
These two nations were not alone. Argentina, Chile, Canada, Australia, Malaysia and Indonesia rode the wave of a continuing economic boom in China.
Strong exports from these countries aided good overall economic growth and business profits. There was a need for investment in new infrastructure — public and private — to help meet the export demand. Local stock markets were doing well, as were bonds in countries with viable bond markets.
So U.S. and Europe-based fund managers and traders started to pile large sums into these countries. But you cannot buy shares on the Sao Paulo stock exchange with dollars or euros. You need Brazilian reals.
So putting large amounts of investments in these countries prompted greater demand for their currencies, which then rose in price. It took more dollars or euros to buy a Brazilian real, Peruvian sol or Indian rupee. In the unfortunate common terminology, these currencies became “stronger.”
A “stronger,” or more expensive currency, makes imports cheaper. This pleases consumers and helps keep inflation down. But it hurts producers, since competing imports are cheaper and their own products are more expensive in world markets. Hence, it usually hurts employment and growth in output. That is why in 2010, Brazilian officials denounced the “currency wars” of which their nation seemed an innocent victim.
But such portfolio investment, unlike U.S. or European companies that build actual factories in these countries, can leave as quickly as it comes in. That is what is happening now.
And when lots of people are trying to get money out of a country, many reals, sols or rupees are being offered to the highest bidder. This increase in supply drives the price down. This means sellers receive fewer dollars or euros for each unit of the currency they are trying to get rid of.
This “weakening” of the currency makes imports more expensive, thus inducing some inflationary pressures. It makes it harder for businesses and for governments to service loans contracted in foreign currencies. It does curb imports and stimulate exports, however.
It is especially severe in India, which is a bit of a special case since it did not boom because of natural resource exports the way that Brazil and Peru did.
Rather, economic reforms begun in the 1990s that included opening India up to foreign firms and foreign portfolio investment had spurred economic growth and a high level of capital inflows.
One may well ask why, if countries complained about excessive inflows just a few years ago, are they now complaining about outflows.
The answer is that abrupt fluctuations in exchange rates, driven by mercurial flows of capital back and forth to wealthy countries, creates a tumultuous climate for domestic businesses. It becomes difficult to evaluate whether to expand or invest in new equipment and facilities.
Economists tend to ignore such “adjustment costs.” But such costs are real and substantial. And dramatic falls in currency values create headaches for governments and central banks that must come up with the foreign currencies needed to pay for essential imports and service pre-existing foreign debt.
Should we change our own monetary policies out of concern for their effects on other countries? No, but we do need to realize that our extraordinary policy reactions to the financial crisis do harm others. And recessions in major developing countries can feed back to our own.
The lesson is that economists in general need to pay more attention to stability as a criterion for judging economic policies and not just the “efficiency and equity” factors that all introductory econ students learn.
With India, Indonesia and Malaysia all experiencing some difficulty, are we in danger of going back to new Asian financial crisis such as we faced in 1997?
No, probably not, although India’s problems are deep and go far beyond the immediate ones due to capital outflows. That is not good news for the global economy as a whole, even if it won’t affect us immediately or deeply.