Emerging economies are entering into an economic and political paradigm where instating capital controls on foreign investment increasingly seems like a viable option.
The economic aspect of this probable outcome relates to a trilemma found in international finance called the ‘Impossible Trinity’. Formally known as the “Mundell-Fleming model”, the impossible trinity frames a choice between three financial policy goals: 1) domestic monetary autonomy, 2) free-flowing foreign capital flows, and 3) a stable exchange rate. Only two of these three goals can be pursued at any given time. The third policy goal is automatically excluded. To illustrate how the impossible trinity works, consider the following example. Say that a government wishes to maintain a stable exchange rate. Given the impossible trinity, the government has two choices to counter the effects of global financial markets on the value of their currency. One option is to give up domestic monetary autonomy. In order to maintain a stable exchange rate, the government must design its monetary policy specifically to counter the appreciative or depreciative pressure that foreign capital flows exert on their currency. This scenario becomes ever more unlikely as global financial markets grow larger and the capacity for governments to influence them through their monetary policy instruments diminishes. Therefore, to maintain a stable exchange rate, governments really have one other option: to establish capital controls. This scenario’s likeliness increases if certain economic and political developments are considered.
From an economic perspective, the focus is on trade. For emerging economies, their economic growth during the last decade owes much to a surge in intraregional trade. MERCOSUR, the SADC, and the ASEAN organizations have consolidated Brazil, South Africa, China, and South Korea as regional economic leaders. These economies have grown to a capacity where they can be strong exporters. Regional trade deals constructed around these regional organizations have consolidated this position for them. However, to maintain a strong trading position, emerging economies have an interest in maintaining stable exchange rates, and hence, keeping prices stable for trade. Therefore, emerging markets already have one policy goal defined for them: stable exchange rates. Now they have to choose between capital controls and surrendering domestic monetary autonomy. It is in this choice, where politics, both domestic and international, factor in.
The global economic downturn of 2008-2009 was mostly a financial affair. Consequently, governments across the globe remain wary of allowing “global financial markets” to hold any significant influence in their economies. Additionally, the financial crises that provoked the economic downturn emerged in developed nations, particularly in the United States. Therefore, governments in emerging economies will be looking to reaffirm their economic autonomy, as they seek to distance themselves from the ‘global west’. Surrendering domestic monetary autonomy, predictably, is not in that playbook.
Another factor to take into consideration is the policy planning of governments in emerging economies. Many of these governments lean towards the left, and their constituents expect more government investments into the economy to go along with their exceptional economic growth. In order to deliver these policy goals which require large investments in defense, infrastructure, and welfare expenditures, governments will need to rely on a stable and dependable pattern in the formulation of monetary policy. So, governments with left-oriented policy goals, would be expected to choose to establish capital controls, rather than surrendering their monetary policy autonomy. Among emerging economies, two exceptions can be found to this trend: South Korea and Chile. The governments in these economies are center-right oriented, and are expected to be a bit less enthusiastic about government investment in the economy. In South Korea, however, the shadow of the Asian debt/currency crisis of the 1990s is still powerful enough to override concerns of government involvement in the economy, and prompt the government to establish capital controls to avoid a repeat of the Asian crisis. In Chile, the prospects for restrictions on foreign capital flows seem far less likely, and its steady economic progress along with recent admission into the OECD makes this country an underrated prospect for foreign investors.
The final piece in this international finance puzzle is China. Investors should not worry about capital controls in China, they are already in place, and there is no sign of any breakthrough in investment liberalization yet. The way China exerts influence in this scenario is through exchange rates. China’s undervalued currency is forcing other emerging economies to maintain their exchange rates lower than they really need to be in order to remain competitive in export markets. Therefore, the level to which emerging economies can afford to raise their interest rates is much lower than it needs to be. As global financial markets exert inflationary pressures on the value of the currencies of emerging markets, along with a decrease in the value of the dollar (which exerts inflationary pressures for all monetary systems, floating and fixed), restrictions on foreign capital flows may have to be resorted to sooner than many economic factors indicate. In fact, Brazil already established a 2% tax on foreign capital flows. On the other hand the Brazilian Central Bank announced in January 2011 that it would raise interest rates by 50 basis points in order to combat rising inflation. These developments reflect that the choice between capital controls and domestic monetary autonomy for Brazil is still not clear.
Hence, as almost everything else in international economics, the establishment of capital controls is far from certain. After all, governments in emerging economies still pay close attention to their reputation in global financial markets, especially in those economies that depend highly on foreign capital flows to finance their development. Nonetheless, all the factors to take into consideration for governments to make their choice in the context of the impossible trinity have been laid out. So we already know what governments are looking at when they make their respective policy moves. The extent to which or even if governments establish restriction on foreign capital flows in emerging markets will serve as a reliable indicator of how much these governments value foreign capital, global financial markets, and monetary policy instruments. Therefore, by closely following developments in the establishment or non-establishment of restrictions on foreign capital, investors should be able to expect what development paths these emerging economies will take for the future.
-Abraham Mercado ’12