The Hindu Business Line : Emerging markets: Too little risk, too much reward?

The debate on managing capital flows in emerging economies rages on. Even a child now knows the ‘impossible trinity’ — capital mobility, market-determined interest and exchange rates — cannot live in peaceful coexistence. Yet the developing world has long been inundated with advice by ‘free market’ economists and multilateral institutions, such as the World Bank and International Monetary Fund, on keeping its doors open to foreign investment and allowing markets to determine currency values. The general refrain was that developing countries’currencies are overvalued, inhibiting exports and encouraging exports.

That advice was perhaps right for bygone times, when domestic and global financial markets were much smaller and less developed than they are today. Most of the third world was hard put to attract foreign capital of any kind. Since global financial institutions were unable to meet the funding and know-how needs of assisted countries on their own, they advocated foreign investor- friendly policies to bridge the resource gap.

Change in scenario

Since the nineties, the scene has vastly changed. Most developing countries welcome foreign investment with open arms. In countries like India, the financial market infrastructure is fast catching up with the best in the world. It would be no exaggeration to state that it is our physical infrastructure which is inferior. (Does it speak of our priorities, one wonders).

Along with free inflows and outflows of foreign investment comes (unwanted) currency fluctuations. It could (and does) happen that the normally adverse impact of a negative trade balance on the currency is overwhelmed by capital flows rushing in to take advantage of a booming stock market and property.

Currency appreciation

The effect of this on the exchange rate would be the opposite of what is required to correct a trade deficit–depreciation. Unwanted appreciation of the currency not only worsens the economy’s international competitiveness but also amplifies the returns to foreign investors on top of the handsome profits in local currency.

If the country’s central bank intervenes to check currency appreciation, it only adds fuel to the fire. The liquidity created through intervention drives asset prices further upwards. The monetary intent of the central bank is made subservient to the exchange rate battle.

Much the same has been happening in India in the last few years following its leap to the super-growth league and enormous attraction to foreign investors. Attention is focused on the quantum and volatility of their flows but the huge repatriated profits merit equal importance.

It all seems to boil down to the risk-reward ratio. Emerging markets, in general, are clearly extraordinarily underpriced. Unless this phenomenon disappears, the impossible trinity will continue to flummox their central banks.

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