from Follow the Money

I am not sure there is much risk that emerging economies will become too enamored with floating any time soon.

May 23, 2007

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Emerging Markets

Dani Rodrik poses an important question on his blog:

“If forced to choose between a world in which developing countries are growing rapidly but there are global macro imbalances associated with it, and one in which current account imbalances are smaller but there is less growth in poor nations--which one would you pick? I would go for the first.

Of course, the essential point is that we have to get the right mix between these two objectives. Arguably, we have sacrificed macro balances too much in the last few years. But as we go about redressing this, we better not forget the role that the level of the real exchange rate plays in developing nations, and not become too enamored of floating.”

I do believe, as I think Dr. Rodrik does, that we have sacrificed global macro balances too much over the past few years.  And, like Dr. Roubini, I also worry that rapid reserve growth is creating a ever-larger internal imbalances in many countries.  Two examples: China’s stock market and dangerously low (negative actually) real interest rates in most oil exporters.

I am not sure that countries like Russia and Brazil who attract very large capital inflows (in part because of interest rates than are higher than US rates) but just use the resulting inflow to add to their reserves are really doing much for their growth either.  In effect, they are borrowing from abroad at a loss to build reserves they no longer need.  Funds parked in central bank reserves are not invested in the local economy; they instead are lent back to the US and Europe.   

Russia’s reserves increased an incredible $14b in the first week of May. Brazil’s reserves are rumored to have increased – counting off balance sheet intervention through the sale of reverse swaps – by something like $15b in the first two weeks of May and Brazil is still in the market.   Those are big numbers.   Reserve growth in the emerging world now seems to running at a $100b a month pace, if not slightly higher.

As Martin Wolf notes, it is hard to square that kind of reserve growth with the argument that the emerging world currently floats.  

Wolf writes:

“The scale of the reserve accumulation demonstrates the obvious: these countries have refused to adopt the freely floating exchange rates many outside economists recommended. They have, instead, chosen to keep their exchange rates down. This, in turn, has generated current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. One instrument they have used has been sterilisation of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness.”

So I don’t think that there is much risk that too many countries will soon become “too enamored of floating.”   i certainly wouldn’t recommend that China move immediately to a free float.   A bit more controlled appreciation though would be very welcome!

Yes, I do think that intervening to hold down the nominal exchange rate – if sterilized – can have a meaningful impact on the real exchange rate for an extended period of time.  In this week’s big blog debate, I side with Wolf, DeLong and knzn.

That said, I have struggled to reconcile my obvious concern with the imbalances associated with very rapid reserve growth in the emerging world with another of Rodrik’s long-standing arguments – namely that we should allow countries enough policy space to find approaches that work for them, and not insist too strongly on a uniform approach to economic policy.    

Rodrik's argument has long appealed to me.  I believe, for example, there should be room in the global economy for different approaches to health care and labor market regulation.   

What then is wrong with allowing countries enough policy space to maintain undervalued exchange rates and add rapidly to their reserves if the result works for them?

My tentative answer is that there are much stronger global spillovers from targeting an undervalued exchange rate than from different approaches to say labor market regulation.   

China doesn’t just set its own exchange rate when it targets the RMB/ dollar.  It also sets the United States exchange rate with China.   And since many other countries feel forced to intervene to keep from appreciating by too much against China, China’s policy also influences the United States’ exchange rate with many of its other trading partners.

That has one other implication:  I suspect that China’s desire to maintain sufficient “policy space” to keep the RMB at its current level has reduced the policy space effectively available to other emerging economies, not just to the United States.

Josh Bivens wrote back in February:

“the Chinese peg severely restricts the policy space available to the non-Chinese developing world in integrating with the global economy. The monetary authorities in a range of other East Asian nations have expressed the desire to hold fewer dollar reserves, but to keep from losing market share in the U.S. economy, they have to make sure their own exchange rate vs the dollar doesn't stray too far from China's, so, they are essentially forced by the Chinese policy into intervening in the exchange rate market.

Brazil has begun intervening in the real/dollar market as well, as China has started sucking U.S. market share away from essentially all other developing countries, not just those in East Asia.

Indeed, besides the institutions and policies of the Washington Consensus, the single biggest encroachment on the policy-making space of the developing world right now is the Chinese exchange rate policy.”

Bivens goes a bit further than I would in some ways that i would.  I rather suspect that the “institutions” of the “Washington Consensus” -- notably the IMF, have a lot less influence on emerging market’s policy choices right now than they had in the past.  But I do think the impact China’s peg is having on a range of countries, not just the US, deserves a bit more attention.