The virus pandemic of which we are all now victims is having a hugely negative impact on the flow of people, goods and services internationally. But what about capital? Will capital keep flowing freely when little else is?
There is a decent case to make that we might be approaching a world in which policymakers start to restrict the movement of capital in the same way that they are restricting the movement of people and goods. Experiments with capital controls, in other words, are probably a step closer.
By some accounts, outflows from emerging markets bond and equity funds in the past three weeks have exceeded 4 per cent of net asset value. This is a much bigger withdrawal of funds than at the same stage of either of the past two big crisis episodes for capital flows to emerging economies: the May 2013 Taper Tantrum and the September 2008 collapse of Lehman Brothers.
In other words, the collapse in external financing for emerging economies now taking place may be unprecedented. In a rush for the relative safety of dollar cash or equivalent, asset prices and currencies in emerging markets might continue to look highly vulnerable.
The good news is that most large emerging economies lack big current account deficits, possess relatively plentiful stocks of foreign exchange reserves and don’t face large near-term surges in the principal repayments that their borrowers must make to foreign creditors.
So, by most measures of financial resilience, many emerging economies look relatively “safe”. One important reason for this is that the legacy of the 1980s and 1990s — two decades of intermittent financial crisis for these countries — has left them cautious when it comes to managing their net debt burdens.
In a “standard” crisis, this would be very good news, because in a standard crisis policymakers in emerging markets would make use of their two most valuable tools to absorb this kind of shock: letting the exchange rate weaken, and selling reserves.
The Financial Times is making key coronavirus coverage free to read to help everyone stay informed. Find the latest here.
And to be sure, that’s what we’re seeing this time round. But since there is nothing “standard” about this crisis, it may not be enough.
It is rational for a policymaker to sell reserves and allow the currency to lose value if the underlying cause of the capital outflow might soon disappear. If the expected value of future net capital inflows remains positive, it makes sense to keep selling dollars today.
But policymakers, like the rest of us, know nothing about when Covid-19 will end. And so their willingness to keep selling dollars to fleeing investors, both domestic and foreign, could run out.
This is particularly true because of a contradiction that is emerging between risk and risk premium, which in some ways are moving in opposite directions to each other.
On the one hand, public debt burdens in EM are under widespread pressure to rise, either because of automatic fiscal stabilisers, or because of discretionary measures to protect citizens from the economic costs of the virus. Risk, in other words, proxied by the debt/GDP ratio, is going up. It should be self-evident that emerging economies do not have the same kind of fiscal room that advanced economies like the US and UK have.
But on the other hand, some measures of the risk premium — embedded, for example, in a country’s policy rate — are declining as central banks ease monetary policy to protect the balance sheets of domestic firms and households.
This might be a problem. Protecting the domestic economy might require lower rates, but protecting the capital account — in other words, preventing large capital outflows — might require higher rates, especially if debt burdens are rising.
The only way to resolve this contradiction, in principle, is to close the capital account.
Coronavirus business update
How is coronavirus taking its toll on markets, business, and our everyday lives and workplaces? Stay briefed with our coronavirus newsletter.
Defaulting on debt is one way of doing this, and to be sure there will be defaults. But there are other options, including restrictions on domestic banks’ ability to sell dollars to their clients — through taxes, differential exchange rates, or outright bans.
That didn’t really happen after the Lehman collapse. But aside from the uniquely horrible features of the current crisis compared with the past, there are two additional differences between then and now.
The first is that we no longer live in a world where “capital account fundamentalism” — the principle that countries should strive at all costs to keep capital markets open and free — holds as much sway as it used to.
The IMF’s tune has changed about restricting capital movements, and its new Integrated Policy Framework — the Fund’s attempt to inject some flexibility into the advice it gives to member countries — is moving towards greater tolerance of ad hoc restrictions on capital movements.
The second big difference is the Trump administration’s ‘America First’ foreign policy framework. The US government seems unlikely to support the most obvious way of boosting international liquidity, namely to allow the IMF to credit hundreds of billions of new Special Drawing Rights to the accounts of IMF member countries.
Things might change in the coming weeks. But as things stand, the longer the virus stays with us, the more capital mobility across EM might be threatened.
David Lubin is head of emerging markets economics at Citi.
beyondbrics is a forum on emerging markets for contributors from the worlds of business, finance, politics, academia and the third sector. All views expressed are those of the author(s) and should not be taken as reflecting the views of the Financial Times.