Capital controls better than rate rises to battle inflation

ECONOMIC growth in emerging markets is more than twice that in "advanced economies" - 7.3 percent versus 3 percent in 2010 - according to estimates by the International Monetary Fund.

Not surprisingly, they are attracting capital inflows and featuring higher inflation rates - 6.2 percent versus 1.6 percent. This is the case in much of Latin America.

In its recent World Economic Outlook, the IMF recommends monetary tightening in emerging markets and continued monetary accommodation in the advanced economies. Alas, both pieces of advice could breed protectionism if not accompanied by effective capital controls.

Most Latin American countries feature strong economic fundamentals, and part of their inflation merely reflects a high weight for food - much higher than in advanced economies - in their calculations of the consumer price index.

But this time inflation is not accompanied by exchange-rate depreciation. Quite the contrary. As a consequence, raising nominal interest rates would translate into real interest rate increases that would widen differentials with advanced economies, thereby attracting even more short-term capital.

Little sense

While that might be fine for financial investors, it makes little sense to raise interest rates to confront price increases for food and oil, which already slow the economy by reducing real wages and cooling off production. But let's set aside that discussion and assume that interest rate increases are necessary to address "second-round" effects on price stability. Even so, the advice is dubious.

Faster growth and stronger fundamentals are attracting capital inflows into countries like Brazil, Chile, Peru, Colombia, and Uruguay. Wider real interest rate differentials with advanced economies only compound their appeal and amplify expectations of exchange rate appreciation.

This, on its own, is posing a challenge to the competitiveness of some domestic industries. But, on top of that, China has been significantly more successful than Latin American countries in stemming upward exchange rate pressure. Additional short-term capital inflows, accompanied by calls for protection of domestic industries, could easily turn "currency wars" into "trade wars" - a risk that could be compounded if the Doha Development Round ultimately fails.

The intrinsic volatility of short-term capital inflows is another reason for emerging markets to continue accumulating foreign currency reserves, thereby insulating their economies from sudden out-flows.

An appetite for additional reserves is understandable, but also troubling, because it requires current account surpluses - one of the primary catalysts of the recent global financial crisis. At a time when advanced economies must close their fiscal deficits, current account surpluses could have a deflationary impact on the global economy.

Reserve accumulation to defend the economy from sudden capital outflows could also compound one of the most disquieting lessons of the crisis. Indeed, if we had to choose only one reason to explain why the crisis did not hit emerging markets harder than advanced economies - as we would have expected - it is that the former had most of their assets in dollars and most of their liabilities in their domestic currencies.

So one of the main lessons of the crisis is that accumulating reserves shelters an economy from imported crises, thereby permitting governments to implement counter-cyclical policies. This is true, but, in an integrated world economy, it assumes that export-led growth is still an option.

In an environment of high liquidity, in which Latin American countries are far less successful than China in fending off capital inflows, advising them to raise real interest rates can only lure more short-term capital, compounding appreciation pressures. Nobody should be surprised to see trade tensions.

So, what should be done?

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