By Kevin P. Gallagher (FT, July 10)
The development process can quickly unravel when a herd of speculative investors steers into a country. Brazil boldly attempted to regulate such speculation in 2010 and 2011. Their efforts were a modest success, but developing countries can’t bear the full burden of regulating cross-border capital flows.
“Hot money” in the form of short-term debt, currency trading, stock market, real estate speculation, all stampeded into emerging market developing countries in 2010 and 2011. Low interest rates in the developed world and higher rates in emerging markets triggered such financial flows. The fact that developing countries were growing faster than crisis-plagued industrial nations played a role as well. Via the carry trade, investors borrow dollars and buy Brazilian real. Then they short the dollar and go long on the real. Depend on the leverage factor an investor can make, well, a ‘killing.’
The massive inflow of foreign capital caused currency appreciation and asset bubbles. From 2009 through 2011 Brazil’s currency appreciated by over 40 percent. When a currency appreciates, exports get more expensive relative to those of other nations. Workers can be laid off and/or wages suppressed. Small and medium sized enterprises that sell to exporters lose key markets. Demand slows overall and puts a drag on growth. Indeed, excessive capital inflows and related problems are part of the reason why growth is slowing in Brazil.
Brazil attempted to cool such speculation by slapping taxes on foreign purchases of stocks, bonds, and currency derivatives numerous times over the past few years. Indeed, Brazil introduced real innovations to the world of capital account regulation. As other nations have, Brazil taxed non-resident equity and fixed income portfolio inflows—starting with a modest level of taxation and then ratcheting up as markets responded. However, Brazil also placed taxes on margin requirements of foreign exchange derivatives transactions. Moreover, Brazil required a non-interest reserve requirement for bank’s short dollar positions in the foreign exchange spot markets.
New research by Brittany Baumann and me shows that Brazil’s efforts were moderately successful. We performed a series of statistical analyses to examine the extent to which Brazil’s regulation of cross-border finance reduced exchange rate volatility and associated problems. We found that Brazil’s measures mitigated exchange rate volatility in Brazil, changed the composition of investment toward more longer run, productive investment, and gave Brazil more say over monetary policy.
We also examined Chile, who faced similar problems but chose to spend billions of dollars intervening in their foreign exchange markets rather than regulating global finance. In contrast with Brazil, we find that Chile’s efforts were not successful.
That said, we find that overall, Brazil’s regulations had a very small impact on cooling hot money flows and were not enough to significantly mitigate the harmful effects of speculation. For the regulations to be more successful they would have had to been much stronger on Brazil’s end, and coupled with regulations at the source of the hot money —namely in the United States.
Economists dating back to Keynes have long stressed that financial flows need to be governed on ‘both ends’ of a transaction. The source of footloose finance is in the United States where interest rates are low. Rates are low in the US to spur dragging growth and employment in that country. Yet, loose regulation makes it more profitable for financial firms to pull money from the US and invest it overseas. To avoid this problem the US had a tax on the outflow of finance in the 1960s and 1970s.
Measures in both the US and places like Brazil would presumably be win-win on many fronts. The US would have more liquidity for productive and employment- based growth at home. Developing countries would not be subject to disruptive investment from abroad.
The proposed Volker Rule would make it harder for US banks to speculate on foreign countries via the carry trade with US deposits. But the financial lobby will have nothing of it. Moreover, financial interests have snuck measures in US trade treaties that make it illegal for trading partners to regulate cross-border finance as well.
Until the US recognizes its interests more clearly, countries like Brazil, that does not have a trade treaty with the US, will have to bear the burden. Brazil has shown such measures can work, but they will have to be much more bold and the developed world will eventually have to come to their senses. The US economy, and development prospects will be all the better for it.
Kevin P. Gallagher is associate professor of international relations at Boston University and co-chair of the Task Force on Regulating Global Capital Flows for Long-Run Development. With Brittany Baumann he is the author of the new study “Navigating Capital Flows in Brazil and Chile.”