September 30, 2013, 3:57 PM ET
Emerging Markets Urged to Take Taoist Approach to Capital Flows
ByIan Talley
Emerging markets could do well to apply an ancient Chinese wisdom their economies. Confucius said: “The green reed which bends in the wind is stronger than the mighty oak which breaks in the storm.” (Or for Bruce Lee fans, “Bend like a bamboo.”)
That, in essence, is what the International Monetary Fund is recommending for China and emerging market economies seeking to better weather the type of capital flow squalls expected when the Federal Reserve starts winding down its easy money policies.
“What we’re trying to emphasize here is not a hard response to capital flows, but a bending response… the concepts behind the yin-yang and the Taoist approach” says senior IMF economist John Simon at a press briefing.
“Instead of trying to oppose it directly, you bend, and thereby you encourage capital outflows instead of trying to stop the capital inflows in the first place,” said Mr. Simon.
Over the last several years, investors plowed their cash into emerging markets, seeking higher returns than in the U.S., where the central bank has been trying to jumpstart growth with cheap cash. But now the Fed’s considering an exit as the U.S. economy recovers and investors are pulling their capital out of emerging markets. Those collective portfolio adjustments threaten to capsize many less developed economies around the globe, tempting some authorities to restrict the free flow of capital across their borders.
The IMF reversed decades of institutional bias against the use of so-called capital controls in 2011. It said that in some circumstances, countries might need to constrict the flow of capital in or out of their economies to prevent financial meltdowns.
But, that’s not the fund’s recommended best practice.
Rather, emerging markets wanting to insulate their economies from a Fed easy-money exit should look to Malaysia as a model.
Deeper and more mature financial markets, a flexible exchange rate and prudent government spending gives the South Asian economy a buffer than can offset foreign capital flight that can be crippling to an economy, the IMF says in a paper released Monday, “The Yin and Yang of Capital Flow Management: Balancing Capital Flows with Capital Outflows.”
In particular, those policies have cultivated domestic investors whose international assets can be repatriated in a crisis. Just as a central bank can use its reserves of international currencies to prevent a fire sale of assets as foreign investors leave, private investors can sell some of their international portfolios and help support domestic markets, the IMF says. In fact, the fund says domestic private investors are able to do most of the heavy-lifting instead of central banks in capital flow crises.
A heavily managed exchange rate, on the other hand, may undermine residents’ incentives to offset outflows because of fear their investments may lose value under a depreciating currency, the IMF said.
That, in essence, is what the International Monetary Fund is recommending for China and emerging market economies seeking to better weather the type of capital flow squalls expected when the Federal Reserve starts winding down its easy money policies.
“What we’re trying to emphasize here is not a hard response to capital flows, but a bending response… the concepts behind the yin-yang and the Taoist approach” says senior IMF economist John Simon at a press briefing.
“Instead of trying to oppose it directly, you bend, and thereby you encourage capital outflows instead of trying to stop the capital inflows in the first place,” said Mr. Simon.
Over the last several years, investors plowed their cash into emerging markets, seeking higher returns than in the U.S., where the central bank has been trying to jumpstart growth with cheap cash. But now the Fed’s considering an exit as the U.S. economy recovers and investors are pulling their capital out of emerging markets. Those collective portfolio adjustments threaten to capsize many less developed economies around the globe, tempting some authorities to restrict the free flow of capital across their borders.
The IMF reversed decades of institutional bias against the use of so-called capital controls in 2011. It said that in some circumstances, countries might need to constrict the flow of capital in or out of their economies to prevent financial meltdowns.
But, that’s not the fund’s recommended best practice.
Rather, emerging markets wanting to insulate their economies from a Fed easy-money exit should look to Malaysia as a model.
Deeper and more mature financial markets, a flexible exchange rate and prudent government spending gives the South Asian economy a buffer than can offset foreign capital flight that can be crippling to an economy, the IMF says in a paper released Monday, “The Yin and Yang of Capital Flow Management: Balancing Capital Flows with Capital Outflows.”
In particular, those policies have cultivated domestic investors whose international assets can be repatriated in a crisis. Just as a central bank can use its reserves of international currencies to prevent a fire sale of assets as foreign investors leave, private investors can sell some of their international portfolios and help support domestic markets, the IMF says. In fact, the fund says domestic private investors are able to do most of the heavy-lifting instead of central banks in capital flow crises.
A heavily managed exchange rate, on the other hand, may undermine residents’ incentives to offset outflows because of fear their investments may lose value under a depreciating currency, the IMF said.
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