Thursday, February 4, 2010

Capital Controls Around the Corner? You Betcha!

These days we live in the world of mantras, repeated ad nausea um by the various media outlets till people accept them as facts, without so much as a question: "fair and balanced news", "exports are the way out", "chase growth in emerging markets", "China should allow yuan to appreciate", "they hate us because of our freedom" - some true, some not true.
Currently the one mantra we see repeated most often is that: with American and Western equity markets topping out, returns will come from investing in high growth markets like the BRICs. While the statement itself is TRUE, the question nobody is asking is "Whether it is Feasible"? The reality is that the BRIC economies are too small (relative to the West's) to absorb every Western fund manager's growing penchant to invest in them. As a very rough estimate (these are off the top of our head so don't hold us down for 100% accuracy) the Chinese equity markets are ~$3-4 trillion; India ~$1-2 trillion and the U.S. is ~$14-$15 trillion.
Will the BRICs allow unrestricted hot inflows of capital into their emerging (i.e. relatively small) economies? And likewise will the West allow unrestricted amounts of capital to flow OUT of their economies at a time when their own governments need it the most to pay for all their colossal deficits? The answer is NO. Going forward we will see more and more restrictions in the movement of capital around the globe, in other words "Capital Controls" will most likely be the next mantra to hit the news wire.
Consider the latest comments from the Reserve Bank of India (the equivalent of the India's Fed). According to a report in the Economic Times:
The Reserve Bank of India (RBI) governor Duvvuri Subbarao has, for the first time, said the nation “may have to take some measures towards capital control” in the short term to avoid stark economic imbalances after acknowledging in the past the role played by fund flows in worsening inflation, boosting asset prices and destroying industry competitiveness. The governor has laid the foundation for a possible action by drawing attention to the fact that most emerging markets face unprecedented flows and that could make decision making difficult for policy makers.
All emerging market economies now believe that capital inflows will increase in the months ahead,” Mr Subbarao said in a teleconference on Monday, the first such event in RBI’s history. “If that happens based on India’s growth prospects, it is possible that the inflows will be much beyond our current account deficit. In the medium-term, it is our objective that India expand its absorptive capacity to absorb the capital flows, but in the short-term should there be flows largely in excess of our current account deficit .... we may have to take some measures towards capital control.”
The RBI governor and the government have been preparing the ground on some kind of action on capital flows for some time following $17 billion of funds flow into Indian equities last year appreciated the Indian Rupee over 10% since end-March 2009, making Indian exports lose to Chinese rivals.
Soaring prices, mainly real estate, is partly due to inflows. The growth prospect of more than 8% and the government bond yields, which are nudging 8% at a time when rates continue to be near zero in developed markets, are luring global funds.
The central bank has been changing gears. “The endeavour in the EMEs will be to strengthen the recovery process without compromising on price stability and to contain asset price inflation stemming from large capital inflows,” the RBI said in its economic review released on January 28.
It followed up with the same assertion while reviewing the monetary policy the next day saying, “Sharp increase in capital inflows, above the absorptive capacity of the economy, may complicate exchange rate and monetary management.”
Although the inflows have caused problems for policy makers in the past, it is a taboo to publicly state that they may be curbed. This is probably the first time since January 2005 that the RBI governor is talking about some measures to control capital flows. In 2005, governor YV Reddy had, in a veiled manner, suggested containing inflows, but later clarified he did not mean that. But recently, countries such as Taiwan and Brazil, in a limited way, have imposed what is popularly known, but disliked by many, as the Tobin Tax. A tax on a transaction to deter speculation.
There may not be a tax or a blunt measure straight away, but tinkering with many instruments as it had done in the past, such as capping interest on Non-Resident Indians’ deposits, limiting foreign investment in corporate and sovereign debt and directing the end use of funds raised overseas. But the governor says he hasn’t made up his mind on which stick to beat with. “We will look at all those measures and also at what other emerging market economies are doing. We will learn from their experience.”
The "new normal" as PIMCO likes to call it is very much underway.

No comments: