Endnotes

¹ In terms of the Swan diagram, the external balance line moves to the right, and absorption increases by the same amount as the capital flow raises demand. A new equilibrium is found with an appreciated exchange rate and non-tradables more expensive compared with tradables.

² Lipschitz et al. (2002) illustrate this point by calculating physical capital per worker in Eastern Europe, which on average, is one-third of the German level. On the bold assumption of the same Cobb-Douglas production function, raising this to the German level would require net investment equal to nearly five times GDP. Even with a combination of domestic and substantial foreign-funded investment, it will take decades to bring the capital stock up to German levels.

³ The borrowers may not feel constrained by the currency risk, as currencies of high interest rate countries tend to appreciate, reducing the costs of their borrowing.

⁴ There is a philosophical issue here. It was often the intention of policy, in the pre-integration regime, to restrain the excessive demand because of a presumption that it was excess, as well as excessive. It often consisted of investment booms and asset bubbles. Are we getting an optimal (or more optimal) outcome by allowing these “excessive” upswings to run their course?

⁵ Krugman (2006) provides the explanation: “For those not familiar with the classics: there were often scenes in Road Runner cartoons in which the ever-frustrated Wile E. Coyote would run off a cliff, take several steps on thin air, then look down – and only after realizing that there was nothing under him would he plunge” (p. 5). There are other inventive explanations, often brave attempts to maintain the rigor of the portfolio balance approach: McKinnon and Pill (1996) see the inflows reversing at the moment when foreign investors realize that the implicit guarantees to banks have been fully used up.

⁶ “The main finding is that push factors are important in explaining banking flows and bond spreads. In the case of the latter, the model suggests that two thirds of the compression in EME bond spreads in the period between October 2002 and earlier this year was explained by push factors alone, and in particular the fall in US short-term rates in 2001. This implies a need for caution by EMEs in borrowing too heavily during times of a benign external financing environment, as a reversal in credit conditions is more often than not beyond the control of the borrower.” Feruci et al., 2004, p. 89

⁷ The yen carry trade seems to illustrate these swings. Most of the time, the interest differential attracts flows to the country with the high interest rate, and pushes up its exchange rate. Every so often, those taking advantage of the uncovered carry become concerned about their exchange exposure, and when enough of them do, this risk is realized in the form of a sudden appreciation of the low-interest-rate country. This appreciation, however, restores the incentive for the carry-trade: the interest differential is attractive and there no longer seems to be an immediate prospect of future exchange loss. So the flow starts again and the recipient country’s exchange rate appreciates once more.

⁸ Emerging countries are not alone in being reluctant to see their exchange rates appreciate: ECB Chairman Trichet called the appreciation of the Euro in 2004 “brutal.”

⁹ Keynes (1929) wrote about this issue as the “transfer” process.

¹⁰ We now know (see Engel, 1995 and Burnside et al., 2006) that not only does UIP not give any guidance on exchange rate movements, but the sign is often wrong: investors usually make a good profit when they invest in high-interest-rate currencies because in addition to the higher interest rate, they usually get an appreciating exchange rate. While forward cover is sold and priced on the basis of the interest differential, no one regards the forward rate as a good predictor of the future movement of the exchange rate (not, at least, since Meese and Rogoff, 1983).

¹¹ Despite persistent profitable interest differentials, capital flows have not arbitraged away the differences. Following fifteen years of pathetically low returns on yen-denominated investments, Japanese investors still have less than 20 percent of their bond holdings, and less than 10 percent of their equity holdings, in the form of foreign assets. IMF World Economic Outlook 2005 Chapter 3

¹² “Much of the discussion on sterilized intervention in Asia suffers from anachronism, since it applies measures consistent with quantity targeting to assess the behavior of central banks with interestrate operating targets” (Ho and McCauley, 2008, p. 6).

¹³ Ho and McCauley emphasize that their results may reflect the particular period under analysis. Earlier exploration of this issue by the IMF (Schadler et al., 1993) report similar results; “In fact, contrary to the fears of policymakers, surges in capital inflows did not, in general, produce concomitant increases in money supply” (p. 23).

¹⁴ I have described it (Grenville, 2004) as like trying to sell discount tickets outside a theatre which is already ablaze, with the patrons streaming out.

¹⁵ It is worth noting that there was no discernable outflow in the earlier exchange rate “crisis” in Australia–the “Banana republic” episode of 1986, when the exchange rate fell 35 percent without any capital outflow, despite the relative novelty of the exchange rate regime, which had floated only eighteen months earlier.

¹⁶ The central bank had the added advantage that it could be seen “to be doing something,” in the form of foreign exchange market intervention.

¹⁷ “In Chile there was widespread fear of a capital flow reversal. Net capital outflows could lead to a balance of payments crisis that would turn out to be much more costly than the contraction brought about by high interest rates. Contractionary monetary policy was seen as a way of reducing the need for external financing (by reducing domestic absorption) and the extent of the capital flow reversal (by sending a pragmatic signal to investors)” (Cabellero et al., 2004, p. 26).

¹⁸ See also Ortiz’s (2000) discussion comparing Australia and Mexico. He identifies different inflation pass-thoughs as an important issue.

¹⁹ Or, if they do not, other investors take their place (and their exposure).

²⁰ The United States provides a more recent example of stable capital flows. Foreigners’ purchases of mortgage-backed securities funded almost one third of the US capital inflow in 2006. When riskratings were re-assessed starting in mid-2007, foreigners sold these assets but continued to hold dollar-denominated assets (IMF Managing Director’s speech Oct 2007).

²¹ Krugman makes the point this way: “But nobody who looks at the terrible experiences of Mexico in 1995 or Thailand in 1997 can remain a cheerful advocate of exchange rate flexibility. It seems that there is a double standard on these things: when a Western country lets its currency drop, the market in effect says ‘Good, that’s over’ and money flows in. But when a Mexico or Thailand does the same, the market in effect says ‘Oh my God, they have no credibility’ and launches a massive speculative attack” (Paul Krugman “Latin America’s Swansong” at http://web.mit.edu/krugman/www/swansong.html).

²² In the Douglass North (1990) sense of rules and norms which govern relationships between market participants.

²³ It might be noted in passing that inducing volatility or uncertainty into market prices is sometimes put forward as a desirable thing. This example from the IMF comes very close to advocating a volatile exchange rate in order to create risk: “Policymakers should continue to be pragmatic and allow for greater exchange rate flexibility in order to create two-way risk in the foreign currency markets and promote a rebalancing of growth where necessary, limiting any intervention to efforts to reduce volatility and ensure that market conditions remain orderly.” IMF Regional Outlook Asia Oct. 2006, p. viii.

This seems perverse: reducing the uncertainty in exchange rate movements would reduce the risk premium, and if this results in too much inflow, it would be better to discourage this through some form of tax (with the revenue benefits) rather than through artificially inflating the risk premium.

²⁴ A casual observation of the implementation of dual tax agreements would suggest that they have been written by the investing countries rather than the capital-receiving countries.

²⁵ Because many commentators hold negative views about these, they may conveniently forget that many other countries used this sort of capital control before Chile did: Australia in the 1970s had “Variable Deposit Requirements” that were so powerful in their effect that they had to be abandoned.

²⁶ The IMF IEO (2004) concludes that URR temporarily allow domestic interest rates to be higher, that there is no significant effect on exchange rate; that the volume of capital inflow is reduced although this effect diminishes over time; and that the composition of capital inflows moves towards longer maturities.

²⁷ Tight loan-to-valuation ratios, cyclically variable provisioning requirements and limitations on the accepted value of security seem sensible measures. See Borio and Lowe (2002).

²⁸ For a recent example, see IMF (2007): “these countries had accumulated large unhedged foreign exchange liabilities, as domestic interest rates were higher than international rates and very tightly managed fixed exchange rates had conveyed a false impression of no exchange rate risk” (p. 24).

²⁹ On these issues, see also Goldstein and Turner (2004).

³⁰ A Japanese investor who invested 100 yen at the Japanese official policy rate at the start of 1990 would, by April 2007, have 124 yen. If she had exchanged it into Australian dollars and invested at the corresponding official rate in Australia, by April 2007 her investment, converted back to yen would have been 265 yen, a return nearly seven-fold the home alternative.

³¹ See, for example Schadler et al. (1993)

³² Sometimes this argument is confused with the idea that the capital flow has caused excess demand and thus a fiscal surplus will fix the problem. Of course in a simple Keynesian sense a fiscal surplus reduces demand. But in the context of capital flows, we need a clearer specification of the problem. A capital flow matched by a current account deficit adds as much to supply as to demand, and so does not cause excess demand. The inconvenient aspect of the inflow is the upward pressure on the exchange rate needed to bring about the real transfer, in the form of a current account deficit, and a fiscal surplus would not seem to help here unless it lowers interest rates and discourages inflows.

³³ Even recent IMF analysis still hankers after the simple world of the Impossible Trinity. Here is an example from the support material for the 2006 Singapore Annual meeting: “In fact, in the impossible trinity’ view, an economy can have only two of the following: an independent monetary policy, a fixed exchange rate, and capital account openness. In the textbook version, a monetary loosening to support GDP growth, for example, would trigger incipient capital outflows that would put downward pressure on the exchange rate peg and lead to an unsustainable drawdown of official reserves. Something has got to give.

Capital controls do not offer a durable way out of the dilemma. A margin for policy maneuver can perhaps be reconstituted by recognizing that capital account openness is not an all-or-nothing proposition: capital flows can be managed through capital controls. While attractive as a tactical solution, this approach has limitations in practice. Capital controls may provide temporary ‘breathing space’ for the pursuit of domestic policy objectives but their long-term effectiveness is questionable in sophisticated global financial systems. More importantly, barriers to capital mobility entail costs in terms of a less efficient allocation of international savings and the foregone benefits of the diversification provided by unencumbered trade in assets.” IMF background paper for the Singapore annual meeting 2006.

³⁴ This does not imply, of course, that BBC would necessarily use the exchange rate as the instrument of monetary policy to target inflation, as Singapore does. Australian intervention practices also have some of these characteristics, in that substantial intervention takes place, but only if the exchange rate has departed significantly from what the RBA judges to be a sensible level. Whether or not a formally defined band is best (neither Singapore nor Australia have such bands) and whether this is made public are purely operational issues. A publicly announced band may help to anchor the exchange rate, but will also constrain the flexibility of the authorities in responding to shocks.

³⁵ The common textbook distinction between “sterilized” and “unsterilized” intervention reflects a confusion of operational practice. Any competent monetary authority will routinely sterilize an intervention through its daily liquidity management operations (otherwise system liquidity would be unbalanced). The substantive distinction should be between intervention which is supported by a change in monetary policy and one which is not. Obviously, supported intervention has a greater likelihood of influencing the path of the exchange rate, but the support may not be consistent with domestic monetary objectives.

³⁶ The practical dilemma for policymakers is this. If they intervene quickly, investors may interpret this to mean that the adjustment process has been staved off only temporarily, and will withdraw their funds. If the authorities stay out of the market while the adjustment occurs (or at least in the first major phase of the adjustment) there may be a better chance that investors will think, at every moment in time, that the adjustment is already complete, and will not withdraw their funds. The counter argument, of course, is that the authorities need to get in early with their intervention to avoid the build-up of downward momentum.

³⁷ Most prominently from the Institute for International Finance, the mature country bankers’ lobby group.

³⁸ Of course, if uncovered interest parity held, the higher interest rate paid would be compensated by valuation gains on the appreciating foreign assets. If, on the other hand, the emerging countries have intrinsically higher interest rates (as suggested here), then there will usually be a holding cost reflecting this differential.

³⁹ The issues are made more complex by the accounting rules, which may in some cases bring favorable valuation changes into the profit and loss account (when, e.g. the foreign exchange reserves are ‘churned” in market transactions), to be distributed to the government as dividends, thus creating a hostage to fortune when negative valuation changes occur.

⁴⁰ The US dollar value of the reserves is unchanged, so it can be used to finance the same sized current account deficit.

⁴¹ And, for that matter, much of the rest of East Asia.

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