Wednesday, August 21, 2013

The Lessons of Capital Flight

India has recently made a splash in the financial papers as the rupee has experienced a dramatic and precipitous decline in recent weeks.

Market observers and analysts are attributing much of the decline to investors anticipating the Federal Reserve's tapering of its quantitative easing program later this year. Recent economic data suggests that the economy has recovered to a point where the Fed is finally comfortable with taking its foot off the monetary throttle.

Long term Treasury yields have increased dramatically in the past month. At the time of this writing, the 10 year Treasury note is currently yielding 2.81%. That's up from a yield of 1.65% in the beginning of May, a 70% increase in the span of 4 months.

Assuming no change in the Federal funds rate until December at the earliest, we will have experienced at least 5 years of near zero interest rate. That unsustainable rate has been the cause of innumerable headaches among fixed income investors. In their search for yield, they plunged into riskier and riskier asset classes.

Once people realized the world wasn't going to end, corporate bond markets rallied. First it was the investment grade bonds. Then came the massive (and arguably still ongoing) rally in domestic junk bonds. Desperate for more yield, investors also poured into both sovereign and corporate emerging market debt. India was a huge recipient of Western capital outflows and its domestic stock and bond markets saw huge increases since 2009.

Those outflows have turned into inflows as American investors are withdrawing overseas capital and reinvesting it into domestic markets. As the cost of imports becomes more expensive, India is currently experiencing a surge in inflation, which the central bank is fighting by increasing interest rates. There are a few lessons to take away from this, if you happen to be a central planner for an emerging market country.

1. Seigniorage, seigniorage, seigniorage: It's a weird word. But its definition is very important for a country's capital account. When your currency is at a high point, the best thing to do is to buy as much stuff from other countries as you can. Since you're exchanging real goods and services for pieces of paper that actually lose their value over time, you're coming out way ahead.

Developed economies have sufficiently deep financial markets that do a very effective job of smoothing out the volatility of floating exchange rates via futures contracts for commodities and currencies. But for developing economies that don't quite have the same luxury, it's important for them to take full advantage of a spike in currency valuation. Buy as much capital equipment as you can from the fine folks at Caterpillar, GE, Monsanto, and Dow Chemical.

2. Yield chasers always lose...eventually: The foreign investors currently beating a path to the exit are also taking huge losses even as they're indirectly inflicting inflation on Indian (completely unintentional alliteration, by the way) consumers. Chilean and Brazilian central bankers are less sanguine about their ability to fully exploit lesson 1 and have frequently resorted to capital controls to slow the inflows and outflows of Western capital in their respective countries.

Stability is an asset in and of itself. And as appealing as lesson #1 may seem, it can be extremely hard to follow through in reality. Latin American banks tried to get a handle on it all throughout the 70s, 80s, and 90s and results have been less than spectacular. It's hard to say exactly what a central bank should do when the country is experiencing huge inflows of hot money from foreign investors, but it does seem that many of them do feel like capital controls are part of the equation.

3. It sure is nice to have deep capital markets: Countries like the US don't have to put up with this kinda crap because our economy is large and we also, not coincidentally, have the deepest capital markets in the world. Price stability makes it much easier for the private sector to invest. And price stability is usually the result of careful, measured, and above all else, principled monetary policy that isn't subject to the whims and tempers of populist leaders and leftist central bankers.

Pick a system and stick with it. Any major changes have to be made with as much forewarning as possible so as to not surprise both the sophisticated investor and the man on the street. One thing is for sure, succumbing to political pressure is not good economics.

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