Economic growth in emerging markets is more than twice that in advanced economies (7.3% versus 3% in 2010, according to estimates by the International Monetary Fund). Not surprisingly, emerging markets are attracting capital inflows and have higher inflation rates (6.2% versus 1.6%). This is the case in much of Latin America. In its recent World Economic Outlook, the IMF recommends monetary tightening in emerging markets and continued monetary accommodation in the advanced economies. Alas, both pieces of advice could breed protectionism if not accompanied by effective capital controls.
Most Latin American countries feature strong economic fundamentals, and part of their inflation merely reflects a high weight for food (much higher than in advanced economies) in their calculations of the consumer price index. But this time inflation is not accompanied by exchange-rate depreciation. Quite the contrary . As a consequence, raising nominal interest rates would translate into real interest-rate increases that would widen differentials with advanced economies, thereby attracting even more short-term capital.
While that might be fine for financial investors , it makes little sense to raise interest rates to confront price increases for food (and oil), which already slow the economy by reducing real wages (and cooling off production). But let's set aside that discussion and assume, for the sake of argument, that interest-rate increases are necessary to address "second-round " effects on price stability. Even so, the advice is dubious. Faster growth and stronger fundamentals are already attracting capital inflows into countries like Brazil, Chile, Peru, Colombia, and Uruguay.
Wider real interest-rate differentials with advanced economies only compound their appeal and amplify expectations of exchangerate appreciation. This, on its own, is already posing a challenge to the competitiveness of some domestic industries. But, on top of that, China has been significantly more successful than Latin American countries in stemming upward exchange-rate pressure. Additional short-term capital inflows, accompanied by calls for protection of domestic industries, could easily turn "currency wars" into "trade wars" - a risk that could be compounded if the Doha Development Round ultimately fails.
Moreover, the intrinsic volatility of short-term capital inflows is another reason for emerging markets to continue accumulating foreign-currency reserves, thereby insulating their economies from sudden outflows. An appetite for additional reserves is understandable, but also troubling, because it requires currentaccount surpluses - one of the primary catalysts of the recent global financial crisis. At a time when advanced economies must close their fiscal deficits, current-account surpluses could have a deflationary impact on the global economy. Reserve accumulation to defend the economy from sudden capital outflows could also compound one of the most disquieting lessons of the crisis.
Source: http://economictimes.indiatimes.com
Most Latin American countries feature strong economic fundamentals, and part of their inflation merely reflects a high weight for food (much higher than in advanced economies) in their calculations of the consumer price index. But this time inflation is not accompanied by exchange-rate depreciation. Quite the contrary . As a consequence, raising nominal interest rates would translate into real interest-rate increases that would widen differentials with advanced economies, thereby attracting even more short-term capital.
While that might be fine for financial investors , it makes little sense to raise interest rates to confront price increases for food (and oil), which already slow the economy by reducing real wages (and cooling off production). But let's set aside that discussion and assume, for the sake of argument, that interest-rate increases are necessary to address "second-round " effects on price stability. Even so, the advice is dubious. Faster growth and stronger fundamentals are already attracting capital inflows into countries like Brazil, Chile, Peru, Colombia, and Uruguay.
Wider real interest-rate differentials with advanced economies only compound their appeal and amplify expectations of exchangerate appreciation. This, on its own, is already posing a challenge to the competitiveness of some domestic industries. But, on top of that, China has been significantly more successful than Latin American countries in stemming upward exchange-rate pressure. Additional short-term capital inflows, accompanied by calls for protection of domestic industries, could easily turn "currency wars" into "trade wars" - a risk that could be compounded if the Doha Development Round ultimately fails.
Moreover, the intrinsic volatility of short-term capital inflows is another reason for emerging markets to continue accumulating foreign-currency reserves, thereby insulating their economies from sudden outflows. An appetite for additional reserves is understandable, but also troubling, because it requires currentaccount surpluses - one of the primary catalysts of the recent global financial crisis. At a time when advanced economies must close their fiscal deficits, current-account surpluses could have a deflationary impact on the global economy. Reserve accumulation to defend the economy from sudden capital outflows could also compound one of the most disquieting lessons of the crisis.
Source: http://economictimes.indiatimes.com
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