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IMF forum: No easy fixes for hot emerging markets

Policy-makers in emerging markets need to keep reaching for a broad mix of tools to cope with the heavy capital flows that have caused strong-currency headaches and led to fears of asset bubbles -- because such flows are here to stay.

May 28, 2011 / 09:28 AM IST

Policy-makers in emerging markets need to keep reaching for a broad mix of tools to cope with the heavy capital flows that have caused strong-currency headaches and led to fears of asset bubbles -- because such flows are here to stay.

That is largely good news, said economists and officials at a conference on capital flows held by the IMF and Brazil's finance ministry. Hot economies such as Brazil and Indonesia may see less fallout than some fear when the US Federal Reserve eventually raises interest rates, tightening the tap on cheap funds that flooded into Latin America and Asia in search of higher returns.

But they will need to keep adjusting their policy mixes to distinguish between "good flows" that help economic growth and "bad" short-term flows that can cause volatility, said IMF Chief Economist Olivier Blanchard. While countries should adjust fiscal and monetary policies before moving to capital controls, there is no one-size-fits-all response, he said.

"We have to be open to exploration here," he told reporters at a beach-side hotel in Rio de Janeiro, which is experiencing many of the symptoms of Brazil's boom, like soaring real estate prices and strong credit growth.

"We are not at the stage at which we can tell this is exactly the way we can do it ... we still don't exactly know what the optimal package is."

In Latin America alone, capital inflows have skyrocketed to nearly UISD 270 billion in 2010 from an average of about USD 40 billion between 2000 and 2005, according to data from the Inter-American Development Bank.

Emerging countries have adopted a broad range of measures to regulate inflows and stem currency rises, increasingly resorting to capital controls and so-called macro-prudential measures such as credit curbs.

In recognition of the alarm about huge inflows that are stoking growth and also inflation rates, the IMF last month endorsed the use of capital controls, once considered anathema to its free-market philosophy. Advanced countries want to establish a framework to monitor their use, an approach opposed by emerging markets.

Blanchard and other IMF officials said it was unclear whether such a system was needed because there was so far little evidence that capital controls had a negative, beggar-thy-neighbor effect on other countries.

Here to stay

There was a broad consensus that the surge in flows was more than a temporary phenomenon driven by loose liquidity in struggling developed economies. Rather, it is being driven by a fundamental re-rating of global risk, said Joyce Chang, global head of emerging markets and credit research at JP Morgan.

"This is not a temporary state of affairs. This is what the new normal has become. It could be a cycle but it could be a 25- to 50-year cycle," she said.

"From a capital markets perspective many of us think that capital controls are likely here to stay. Investors will continue to allocate more to emerging market assets given the better fundamentals and higher returns."

Developed world investors are still vastly under-exposed to emerging markets, suggesting that emerging markets need to be prepared for decades of strong inflows. She said U.S. defined-contribution pension plans only have 2.1% of their funds allocated to developing economies, which make up nearly 50% of global GDP.

Flows to countries such as Brazil, which has tripled the tax it charges foreigners to buy local bonds, have remained strong, suggesting that governments have yet to exhaust their policy options, participants said.

"These measures are small. Given the profit opportunities, money is still going to come in," Jonathan Ostry, deputy director of the IMF's research department, told Reuters.

The key to a successful balance of policies may be technical expertise and detailed tweaking of rules to direct inflows to the "right" places. India last year raised the ceiling on foreign investment in long-term bonds, for example, aiming to attract funds for long-term projects such as infrastructure development.

Kristin Forbes, an economics professor at the Massachusetts Institute of Technology, said countries should also consider the role of domestic investors since they are increasingly influential in determining net inflows.

"In the hierarchy of when you should use capital controls, a key question you should ask before even talking about them is: what is driving the surge in net inflows? If it's largely foreigners then there may be a role for capital controls," she said.

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