Serious exchange-rate stress

For over a year now, Latin American policymakers have been increasingly worried about the effect of the large – and growing – economic imbalances in the world economy on the region’s growth and stability prospects. A particular concern is that, in view of extremely low interest rates in developed countries, global investors are currently directing large capital flows to countries like Brazil, Colombia, Chile and Peru. In turn, those countries’ currencies are appreciating and putting upward pressure on asset prices, especially in local real estate and stock markets.

Latin America’s central bankers worry that asset-price bubbles are building up. Moreover, a sudden reversal of the trend cannot be ruled out. The international capital markets are extremely volatile. In the past, sudden stops of capital inflows have triggered major financial crises in Latin America.

Who is to blame for the threats to global financial stability? There are two camps in this international debate. The first ­blames the extremely accommodative monetary policy in developed countries, especially in the USA. This camp argues that the attempts by the Federal Reserve to revitalise growth and employment through expansionary monetary policy are not having the desired effect of increasing domestic demand, but are instead leading to massive capital flows to emerging markets that are considered “good performers”.

The second camp blames China’s interventions in for-ex markets. Supporters of this view include top US officials. They argue that China’s reluctance to allow its exchange rate to appreciate against the dollar prevents the adjustment necessary to correct global imbalances. From this point of view, a faster appreciation of the Chinese renminbi (or equivalently, a faster depreciation of the US dollar relative to the renminbi) would ­lead to a reduction in both the large current account surplus in China and the large current account deficit in the US. By boosting US exports, a higher renminbi would en­hance growth prospects in the US, which would in turn support global growth.

From a Latin American perspective, both the USA and China are at fault. They are at the epicenter of the international currency wars, and they are hurting emerging markets that allow for a significant degree of flexibility in their exchange rates, such as those in Latin America.

It is true that monetary expansion in the United States is putting excessive appreciation pressure on Latin America through increased capital inflows, and it is also true that the appreciation pressure in the region are larger than necessary because China refuses to absorb part of the pressure. The defensive response of some Latin American countries – together with other emerging markets, such as Thailand, and some rich nations, like Japan and Switzerland – has been intervention in for-ex markets and the imposition of capital controls. Colombia and Peru have done the former; Brazil the latter. Chile is not intervening in the foreign exchange markets; at least not so far, as recently noted by its finance minister. Instead, Chile is dealing with its currency appreciation pressures by decelerating government spending. This of course will slow down the country’s economic growth.

What is the answer to this problem? What can stop the currency wars in which individual countries try to avoid appreciation of their currencies, which in turn just magnifies the extent of adjustment that ­other countries have to absorb? The most obvious solution is bilateral coordination between China and the USA. But that does not seem likely any time soon. The hope, therefore, lies in the ability of the G20 to arrange some form of coordination between major economies, including key emerging markets. But time is running short and exchange-rate pressures are growing. Failure to reach a meaningful agreement at the G20 meeting in November will send a signal that the currency wars will intensify. In late October, the G20 finance ministers' pledge to tackle global imbalances and give emerging-market nations more say at the IMF at last inspired hope.