from Follow the Money

What goes in also can go out ...

September 11, 2008

Blog Post
Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Monetary Policy

Emerging Markets

Joanna Slater of the Wall Street Journal notes that many countries that were resisting pressure for upward appreciation are now selling dollars to defend their currencies. I very much agree with the quote from Lisa Scott-Smith:

Earlier this year, many governments in emerging markets were worried that their currencies were too strong, partly because foreigners kept plowing money into their economies.

Since then, investor sentiment has shifted sharply. Fears of inflation have combined with worries over a world-wide economic slowdown. Commodity prices have fallen, bad news for countries that export everything from oil to metals, and the U.S. dollar has mounted a powerful rally. In some cases -- like Russia, Thailand and Pakistan -- turmoil at home or nearby has spurred further unease.

As investors retreat from places they used to favor, many of them emerging markets, it creates a new worry for central banks in these countries.

When too much capital was flowing in, their main problem was that such flows put upward pressure on their currencies. A stronger currency makes exports more expensive abroad, harming trade competitiveness. To curb currency appreciation, central banks would buy dollars, and that led to a large accumulation of reserves.

Now "that is unraveling the other way," says Lisa Scott-Smith of Millennium Global Investments, a London currency manager with $13 billion in assets. With investors unloading local stock and bond holdings, central banks find themselves "on the other side of the trade, trying to smooth currency weakness instead of strength."

As Slater’s article notes, I expect emerging market reserve growth to slow from a level that was well above the emerging world’s current account surplus to a level that is more in line with the emerging world’s surplus. It might even dip below the emerging world’s combined surplus for a bit, as some of the money that went in earlier comes out. In some cases the pace of the reversal in flows has surprised me: I would have thought that high levels of reserves in the periphery might damp down volatility a bit more.

A couple of bits of data will be key to understanding how strong this shift is:

China’s July and August reserve growth

And Saudi Arabia’s reserve growth for those months.

Both still have a large trade surpluses, so there should still be an underlying dynamic of reserve growth. But the pace of their reserve growth likely has slowed in line with broader moves in global markets.

Speaking of Saudi Arabia, let me recommend Robin Wigglesworth’s reporting on Saudi Monetary policy. Wigglesworth reports that the unwinding of speculative bet on the riyal has created a cash squeeze in Saudi Arabia -- pushing up local interest rates. And it so happens that the Saudi Monetary Agency is quite happy to see rates rise, as they want to cool lending to help curb inflation.

Earlier this year, funding costs in the interbank market were subdued by international capital inflows. Local currencies had slumped due to their peg to the dollar, and ambiguous comments from some central bankers around the turn of the year led international banks and hedge funds to bet on currency revaluations to help curb inflation. This helped to subdue borrowing costs for regional financial institutions, but also led local banks to ignore the need to build deposits to match hyperactive lending.

The dollar’s rally this summer also increased the value of Gulf currencies such as Saudi’s riyal, cutting the cost of imports and easing pressure on authorities to revalue their dollar pegs.International banks therefore started to reverse speculative revaluation bets, withdrawing local currency deposits and draining away capital that had helped keep spreads between the money market and benchmark rates low.

Subsequently, Gulf banks have had to turn to local money markets to finance lending, causing interbank rates to climb far above the central banks’ benchmark interest rates. Rather than try to ease the liquidity squeeze, authorities have welcomed more expensive funding costs in the fight against inflation, even abetting it in the case of Saudi Arabia.

Interesting. Reports of capital outflows from the Gulf suggest that Saudi reserve growth won’t be quite as high as one might expect based on the price of oil in July and August. The Saudis also seem have a bit more monetary autonomy when money is going out than when it is coming in -- as they can allow the outflows to push up rates.

Even so, I fully agree with an anonymous Treasurer at a Gulf bank:

"the monetary policy appropriate for the faltering US economy is far from ideal in the Gulf, which has other concerns. Inflation and credit growth are soaring, but “we have monetary policies as if we were in a recession”, says the head of treasury at a top Gulf bank.

Pegging to the dollar isn’t quite as painful when the dollar is rising, but the dollar is still a poor fit for the Gulf’s economy. The Gulf would benefit from a currency that moved in the same way as oil -- not one that often moves in the opposite direction.

More on:

Monetary Policy

Emerging Markets