Financial Crises: Who’s Next?

I’m leaving Malaysia for a short sojourn offshore – figuratively speaking.

East Asia and others gained a salutary lesson 10 years ago during the 1997-98 financial crisis about the dangers of short-term capital flows. We’ve generally applied that lesson today, in the aftermath of the recession and the subsequent flood of liquidity aimed at emerging markets.

Some countries have responded with controls on short term capital flows, of which Thailand’s 15% withholding tax on government bond purchases last week was just the latest. Others, like Malaysia and Singapore, have generally refrained from administrative measures, instead allowing a sharper appreciation of their currencies to limit incentives for portfolio capital inflows and keep a lid on inflation.

Yet others don’t appear to have gained anything from East Asia’s experience:

India’s capital account conundrum

A current account deficit widening at a furious pace, high inflation, a tightening monetary cycle, foreign inflows driving stock prices and an appreciating currency — these form an unusual macroeconomic constellation for liberalising the capital account.

Yet these beeps have been ignored, even as fresh pastures are opened for foreign investors. This also comes at a time when Western grasslands remain dry, the US Federal Reserve is poised to unleash a fresh round of liquidity, investors are rebalancing portfolios toward emerging markets, and other Asian nations are contemplating capital controls to stem the global tide of hot money. India is no exception to this flood: Indeed, with its currency yielding the maximum bang for investors’ bucks, the country is the star among emerging markets...

...The ‘evolving macroeconomic situation,’ meanwhile, is a visible matter of concern. The current account deficit — led by a trade deficit — is widening at a rapid pace. The trade gap grew by some 19 per cent in April-June over the preceding quarter. More recent data shows it increased a further $2 billion in July-August — a 21 per cent jump over the previous quarter.

A capital account surplus is increasingly feeding the deficit. The surplus comes from accelerating short-term inflows, i.e., trade credit and rate-sensitive commercial borrowings, and banking capital. Other data show a gush of portfolio equity inflows — $7 billion in September alone — threatening to turn into a deluge...

...In addition, there’s persistent and high inflation, a tightening monetary cycle, and the possibility that the central bank may not have finished increasing interest rates yet...

...When fundamental indicators suggest a weakening currency (and monetary tightening), but market forces are such that speculative, short-term capital flows dominate the capital account, it is critical to pay attention to the current account and exchange rate movements. Instead, a ‘hands-off’ exchange rate policy and a pro-cyclical liberalisation to invite more capital is the policy choice.

Let’s see now – current account deficit, accelerating inflation, short term portfolio capital inflows, increasing investment, appreciating exchange rate, and capital account liberalisation. India in 2010? Yes, but also Mexico in the early 1990s, and Malaysia, Indonesia, Thailand, and Korea 1995-1996. There’s a slew of other examples as well.

India is becoming increasingly vulnerable to what’s called a “sudden stop” reversal in capital flows – all the more dangerous if India’s corporates have borrowed in foreign currency. There’s a tendency to do that when the local economy has a strengthening currency and domestic interest rates are high. But a reversal of capital flows, for whatever reason, causes a sometimes sharp depreciation of the currency and results in the domestic value of foreign debt ballooning. Investment during this type of boom is typically of the “unproductive” sort, which is par for the course when capital is only invested in financial instruments.

I‘m not familiar enough with the data or know enough about India’s economy to make a call on whether the risk of a financial crisis is increasing, or whether the policy mix is correct – but the parallels to past emerging market financial crises are disturbing. And liberalising the capital account, instead of restricting it, strikes me as exactly the wrong thing to do.