Economic Development – Effects of Capital Flow I

 Capital Mobility and its Effects 

Starting in 2008, investors in the developed world have sought to invest in emerging economies. Due to heavy indebtedness and slow growth of first world nations such as USA and the old economies of Europe, capital has largely flowed to developing countries in search of higher returns. To counter the strong deleveraging which happened in 2008 and to prevent what would have been the Great Depression of the 21st century, central banks of major economies such as the US and Japan kept interest rates low following what is known as ZIRP or a Zero Interest Rate Policy. Interest rates were held at record lows and measures such as Quantitative Easing (QE) which is akin to printing money were also taken to stimulate demand in the economy.

Economic DevelopmentCapital Flows into Emerging Economies

However, an unintended consequence of expansionary monetary conditions was that it drove higher and higher amounts of investment capital into emerging economies in search of higher yields and returns. Carry Trade into Asian Economies reached peaked and commodity prices doubled in China during 2009-11 due to the construction intensive nature of China’s economy. Countries like India, Brazil, and Argentina were in search of higher growth and pursued expansionary policies themselves.

Increasing money supply without a corresponding increase in real output is inflationary as more money starts chasing fewer goods. With a decline in the velocity of money after the financial crisis, the consumption in developed economies was stagnant. However, money at the end has to be used for purchasing goods and services. It will finally “stick” where demand is present. And in today’s globalized world, the loose monetary conditions in the US and Europe prompted this easy money to flow to high consumption economies such as India and China. This can be one of the reasons why inflation was not seen in the US and other developed countries even during periods of such rapid monetary expansion.

Economic DevelopmentThe Imitation Game

The demonstration effect explains the behavior of a person when he tries to copy the spending and consumption patterns of his higher income counterparts. This phenomenon is being seen at an aggregate level as people in emerging economies have started walking in the footsteps of their western contemporaries. They are adopting the spendthrift ways which led to the West’s downfall in the first place. This obsessiveness with luxury is primarily due to the availability of easy money. One of the reasons behind ever rising asset prices in the developing world is this easy liquidity.

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But what if this money poured into emerging economies leaves? What will happen to asset prices if “this liquidity tsunami” is reversed?

Economic DevelopmentThe Bubble Pricked

Money is often, if not always fickle and callous. It seeks to return relentlessly. In today’s globalized and connected world, this unrelenting pursuit of higher returns can drive money to the other side of the globe in the blink of an eye or in literal terms at the click of a button. As investors now react to stronger signals from the US with rising growth, strengthening dollar and rising yields; money is flowing out from developing economies and seeking security with relatively higher returns in the old world. Investors are selling riskier stocks and bonds in emerging markets in favor of safer US assets.

When the interest rates of dollar-denominated debt were at record lows, emerging economies took on large amounts of foreign debt. The fact that if the dollar strengthens this debt will become harder to repay was brushed aside and now the consequences are starting to show. India has one of the worst performing currencies against the dollar this year. Those countries with high levels of foreign ownership of government bonds are at a risk and the rise of the dollar can act as a double edged sword.

Redeeming government bonds for foreign investors by printing money is seen as a viable alternative by some countries. This can run the risk of falling into a hyperinflation spiral. What happened in Turkey can be seen as a prime example. Argentina is making its way through another economic crisis with interest rates being as high as 60% to stem the flow of rising prices. The Argentine Peso has rapidly lost value against the dollar. The net borrowing in terms of percentage of GDP has risen sharply and now the challenge is to sustain this borrowing at a time when interest rates in the US are rising and the dollar is also strengthening.

This effect of easy capital movement from the developed to the emerging economies and the consequences if this flow is subsequently reversed is becoming increasingly necessary to study and analyze according to the recent trend. It becomes important for developing economies to take into account the kind of capital flows entering the economy. Distinguishing capital on the basis of its nature being speculative or “here to stay” becomes important. We will look at the effect of types of capital entering the economy and what can it mean in the long run in one of our later articles. Stay tuned for more!

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