Not so long after the global financial crisis, the supply of foreign financing has become abundant, and cheap, for many emerging market countries. This sounds like good news for Latin America, and it is—creating opportunities for debt management, saving on interest paid to foreigners, and expanding opportunities for investment. But it also comes with a number of potential risks that need to be managed.
Our new Regional Economic Outlook for the Western Hemisphere takes an in-depth look at the risks arising from what we call “easy external financial conditions.” There we analyze how the more financially integrated economies of Latin America have responded to such conditions in the past, with comparison to countries of other regions. Our comparisons focus especially on a group of advanced economies—Canada, Australia and New Zealand, and Norway—that also are commodity exporters, as well as being inflation targeters with highly flexible exchange rates.
We show that easy global financing conditions can lead to booms in domestic demand and credit, and to large current account deficits and capital inflows—an accumulation of risks that can end badly.
But a boom-bust outcome is not a certain fate. Our analysis shows how economies around the world have differed in their responses to cheap foreign money, with their own policies playing a key role. In fact policies can act to mitigate—or enhance—the accumulation of risks during episodes of easy financial conditions.
What are “easy external financial conditions”?
Motivating our study is the fact external financial conditions fluctuate greatly over time. A simple but effective way to capture this variation is to look at two summary indicators:
- Interest rates in reserve currency countries. Our study uses U.S. short-term interest rates, minus expected U.S. core inflation.
- Global risk aversion. A frequently used indicator of global appetite for “risk assets” is the VIX. This financial market indicator turns out to say a lot about the cost of borrowing for emerging market countries, as seen in its close relationship with their bond spreads (Figure 1).
When both these factors are on the low side—as they were for a number of years in the 1990s, and again during 2004-07—we say that external financial conditions are “easy” (Figure 2).
Today we again see such easy conditions. The U.S. real interest rate is unusually low, and is likely to stay on the low side for some time, given the weak state of the U.S. economy. The VIX is also well below its historical average—we assume this condition will last some time also, though this is very far from certain. Note that investors’ concerns over some southern European countries triggered a jump in the VIX and in emerging market bond spreads earlier this year, and again briefly in late April, before settling down.
How have economies responded to easy conditions?
Analyzing the responses of countries of Latin America and other regions, we look at such key macro variables as domestic demand and credit, among others (while controlling for shifts in other factors, such as their terms of trade and world economic growth).
Among the empirical findings is that domestic demand tends to be stimulated by low foreign interest rates and also by low VIX levels—but these effects have been much larger in Latin America than in the comparator group of advanced economies. This demand response comes mainly from the private sector, but governments in Latin America, in contrast to those in the advanced economy group, tended to add on to it by increasing their own expenditure to some degree. The result has been that in Latin America domestic demand tended to grow much in excess of trend output during episodes of easy conditions (Figure 3).
Economic policies have also differed in other ways likely to influence the response to easy money—particularly in foreign exchange policies. The advanced economies’ exchange rates were highly flexible, and currency appreciation helped choke off the foreign-financed growth of domestic demand. Latin American countries now allow much more exchange rate flexibility than in the past, but in 2006-07 many joined other emerging markets in trying to limit or smooth appreciation of their currencies. At the other extreme, some economies in Eastern Europe that held to fixed exchange rates during the same years were among those with the fastest domestic demand growth, bringing large current account deficits amid soaring credit—until the good times ended.
What about capital inflows?
Of course inflows of foreign capital are an essential part of the story, and we show how these have accelerated at times of easy external financial conditions.
Focusing on the amount of capital inflows, however, could miss an important point: the volume of such inflows is not driven only by foreign investors’ decisions. In fact the amount of capital inflows an economy receives is influenced by how its private and public sectors respond to easy global conditions. If private spending reacts strongly to cheap foreign money, this additional spending can drive a widening current account deficit and a demand for foreign money to fund that deficit. And if central banks react to capital inflows with foreign exchange market intervention that tries to hold the exchange rate at a too-weak level—or that excessively limits the rate of currency appreciation and exchange rate volatility—then incentives for new capital inflows will probably grow rather than dissipate.
Policies can help contain risks
In short, episodes of easy foreign money give rise to a range of risks, a situation calling for a set of policy responses. Our analysis underscores the usefulness of allowing significant flexibility of the exchange rate, maintaining fiscal discipline and using fiscal policy to lean against possible excessive demand growth, and applying macroprudential financial policies to dampen unwanted credit booms. If these approaches together turn out to be insufficient, then carefully designed taxes on capital inflows might also be of help, on a temporary basis.
For further analysis of these and related issues, including a discussion of the risks of currency appreciation for economic growth, please see Chapter 3 of the May 2010 Regional Economic Outlook for the Western Hemisphere. Chapters 1 and 2 of that publication analyze the current economic environment and revised outlook for the Latin American and Caribbean region, as well as the United States and Canada.