Excellencies, colleagues, ladies and gentlemen
Against a backdrop of rapidly slowing growth in the major economies there has been much talk in recent weeks of the threat of currency wars. We all know the dangers of this happening but so far proposals to stop it have been vague or absent altogether. Beggar-my-neighbour policies are no more history than stock market panics, bank runs or soup kitchens.
When the Bretton Woods system collapsed, the expectation was that more open and flexible markets, including for currencies, would demonstrate the benefits of unrestricted capital mobility in terms of growth and stability, particularly for developing countries. Instead for much of the subsequent period of finance-driven globalisation, productive investment has stalled and there has been a growing incidence of financial crises, particularly in developing countries.
For a while during the past decade a prolonged debt-driven boom, rooted in the advanced economies, was able to hide the growing fragility of the financial system and almost certainly helped stimulate fast growth across much of the developing world. That moment ended with the collapse of Lehman Brothers 3 years ago.
Most advanced economies, especially the United States, responded to the economic collapse in 2008 through an unprecedented relaxation of monetary policy. Hundreds of billions of dollars were made available to leading financial institutions at near-zero interest rates to stimulate private spending, boost exports and support asset prices. However, indebted consumers have been unwilling to increase their borrowing, governments have embarked on protracted fiscal adjustments, and firms are avoiding investments in fixed capital and inventory accumulation because of lack of demand.
In contrast, many developing countries have been much successful in recovering their growth momentum. With interest rates higher in developing economies, the response from financial institutions has been to shift funds to these countries in search of quick returns, particularly in real estate and equity markets as well as speculating in commodities markets.
Net private financial flows to the 30 most important emerging economies are now very close to their peak in 2007. The rebound has taken place in most regions, with the exception of the CIS and MENA. Developing Asia, Central and Eastern Europe and sub-Saharan Africa have seen financial investors returning at full speed, placing upward pressure on the exchange rates of their currencies. Ironically, those developing countries with the largest current account deficits (Brazil, India, South Africa and Turkey) have experienced the sharpest currency appreciations.
As a result, while many developing economies have successfully avoided the frying pan of financial crisis they are now facing the fire of large and volatile capital inflows. These flows have already stoked asset price inflation, encouraged excessive consumer credit growth and led to an unsustainable appreciation of the currency.
The speculative behaviour of financial institutions is once again feeding on itself. In addition to the initial interest rate differential, investors also gain from the exchange rate appreciation which their actions have generated, fuelling another round of speculative capital flows. The resulting overshooting of developing country exchange rates can distort trade much more than protectionist measures and undermine productive investment programmes.
Moreover, if the flows stop or if they are reversed rapidly, as has happened several times in the past, they could induce currency and maturity mismatches, leading to difficulties in servicing debts and other financial commitments, and triggering a sharp currency decline, defaults, asset price deflation, a credit crunch and economic contraction.
This could happen, for example, because of a sudden tightening of monetary policy in the US (since unprecedentedly low interest rates cannot be maintained indefinitely) or a severe crisis in the eurozone. But a sharp growth slowdown in China or a financial or balance of payments crisis in a large developing country could quickly spread if it triggered a so-called flight to safety. And despite the knowledge gained from the emerging country crises of the late 1990s, little progress has been made at the international level to prevent the spread of financial contagion. Instead, many countries have turned to the costly, and uncertain, option of self-insurance through reserve accumulation.
International regulations and domestic policy measures are urgently needed to limit the destabilising impact of mercurial capital movements and, more broadly, to avoid currency and trade wars. In contrast with the rules-based world of international trade, existing financial arrangements lack effective mechanisms to restrict beggar-thy-neighbour policies by reserve issuing countries or to enforce control on capital outflows at the source.
Monetary policy, even where there is room to use it, can only help up to a point. And for many developing countries, their financial markets are simply too shallow for this option to work in the face of large capital flows. Several emerging economies have introduced macroprudential taxes or regulations on selected inward investment, usually excluding, for example, FDI. Measures adopted include taxes on fixed income and portfolio equity flows (Brazil), on foreigners´ government bond purchases and banks´ foreign exchange borrowing (Korea), or on interest income and capital gains earned by foreigners (Thailand and Korea). These policies have been only marginally effective, because low tax rates are insufficient to discourage inflows when interest differentials are large, stock prices are rising and the currency is appreciating. Moreover, the exclusion of FDI may be short-sighted since its surges can have the same effect on the currency as other types of inflows, and many inflows classified as FDI do not create new productive assets and are similar to portfolio investment.
UNCTAD has long maintained that stronger capital controls are essential. These can include restrictions on foreign borrowing, the entry of non-residents into domestic securities markets and on foreign currency bank accounts and currency transfers; taxes, non-interest bearing "quarantines" or administrative limits on flows of direct and portfolio investment; restrictions on foreign payments for "technical assistance" between connected firms, and multiple exchange rates determined by the priority of each type of investment. These controls can make a difference, if they are imposed vigorously. Managing them will certainly burden the monetary authorities, but this task is not beyond the capabilities of most central banks. The most significant obstacle to capital controls is not technical - it is political.
Experience shows that when policies fail to manage capital flows, international finance can cause unlimited damage, particularly to small open economies. This is now increasingly accepted even by the mainstream, including the IMF. Their recognition reinforces the argument that reforms of the international financial architecture are essential to reduce systemic instability. This task should begin from a recognition that the most damaging swings in capital flows stem from macroeconomic and financial conditions in major industrial countries, and that multilateral disciplines are needed on the policies and financial markets of these countries. In addition to strengthened surveillance, reform measures should include the promotion of capital controls in both source and recipient countries, regulation of trading in commodity futures, the provision of adequate international liquidity and changes to the global exchange rate system.
Movement on the last of these, and particularly among the principle reserve currency countries, has been very slow. This is of concern to all developing countries who have made significant efforts to integrate more closely in to the global economy over the past three decades. However, in a disorderly world, there can be no general rule about which exchange rate system should be followed by these countries. The exchange rate remains an important development tool and its choice should be determined by each country´s circumstances and developmental objectives.
In order to preserve macroeconomic stability, small poor countries with highly concentrated trade patterns and countries where currency substitution is advanced may need to adopt fixed exchange rate systems. This is far from ideal, because supporting an arbitrary peg reduces the scope for developmental and inclusive monetary policies, but it may be unavoidable in the short-term. But other countries enjoy additional degrees of freedom to adopt a managed floating exchange rate regime or, even better, an adjustable peg, which maximises the scope for policy discretion.
Whatever the exchange rate regime, it must be managed carefully. Although overvaluation can offer immediate benefits through cheaper imports and lower inflation, development strategies should normally avoid this type of "exchange rate populism". Currency overvaluation can have destructive implications for domestic production and employment, and it can induce consumption and asset bubbles that may be difficult to neutralise. Experience suggests that export growth and the expansion of employment are more easily obtained with selective import protection, export incentives, capital controls and a moderately undervalued exchange rate.
As I will argue in my report to UNCTAD XIII, one of the paradoxes of the era of FDG is that the winners are those developing countries that have resisted rapid financial and capital account liberalization and have, instead, continued to deploy creative and heterodox policy innovations along the lines of those which had earlier helped South Korea, Taiwan (China), and other countries break their constraints on growth in the 1960s and 1970s. In these and other cases, the key to success has been to use global market forces strategically to fill resource gaps and strengthen local capacities, and manage the country´s trade and financial integration into the global economy.
UNCTAD has consistently argued that FDG has increased the vulnerability of developing countries to shocks, crises and contagion, reduced their ability to respond to these challenges, and prevented the design and implementation of policies tailored to local needs and aspirations. These conclusions have been validated by the developments in the run-up to the current crisis, and in its aftermath. In the absence of global rules and support to correct these threats, regional arrangements deserve more careful consideration.
A number of regional options to manage the threat of financial instability were suggested by developing countries after the Asian financial crises of the late 1990s. These included an Asian Monetary Fund, currency swap arrangements (the so called Chiang Mai initiative) and a regional stability fund. Other mechanisms for regional financial cooperation have more recently been discussed in Latin America, including policy coordination and adjustment. All these deserve closer attention and support from the international community.
These are critically important challenges. In the short-term, developing countries must limit their entanglement in the protracted crisis which has enveloped most advanced economies. This will require a full policy tool kit, including capital controls, and a careful consideration of regional trade and monetary arrangements. But these challenges should not be approached in isolation or from a technocratic perspective. Rather they should be part of an integrated effort to build new and inclusive development paths and to facilitate the emergence of an economically and environmentally sustainable process of globalisation, which UNCTAD calls development-led globalisation.
I will explore these themes in great detail my Report to UNCTAD XIII, and hope that the TDB will join me in these reflections.