Market participants and readers of the financial press will be familiar with the "carry trade" in global foreign exchange markets. This is where, in the absence of exchange controls, a speculator borrows a currency with a low interest rate and deposits it in a currency with a high interest rate. The speculator benefits if the currency with the high interest rate does not depreciate by the same percentage of the interest rate differential or what is referred to as "the carry." The weight of many traders pursuing the carry often lifts the high-yielding currency and so the speculator gets the benefit of being paid for holding on to an appreciating asset. Part of the appeal of the carry trade for traders is that it is both self-fulfilling and it appears to resonate with international macroeconomic theory, where tighter monetary policy leads to a currency appreciation.
Speculation and Carry Trade
Speculation is a pejorative word in many circles, especially in the central banks of emerging economies. In some countries they used to be shot. The idea that a certain amount of speculation helps to oil markets and supports the arrival of the right price is a modern one, and outside of the United States and a few other places, it is confined to textbooks. In these textbooks, the higher interest rate of one currency merely compensates holders for a future depreciation of that currency. When a country tightens monetary policy, the exchange rate overshoots its long-run level to a point from where it will steadily depreciate by the amount of the interest rate differential, which helps to explain the large amount of volatility in floating exchange rates. Rudi Dornbusch should have won the Nobel Prize for his overshooting theory if just for the reason that he was one of a disappearing sort of economist, who tried to fit theory to observations rather than trying to fit the world to theory. The essential point is that in currency markets, the interest rate premium is not a speculator’s free lunch, but compensation for taking a real risk.
International capital flows come in only two modes: feast or famine.
Over some period of time then, the carry trade ceases to work, perhaps because of an adverse economic or political surprise, or perhaps the weight of carry trades had previously pushed the currency over what later emerged as its fundamental value by more than the rate differential. When carry trades begin to submerge, the simultaneous bailing out of these trades can lead to a sharp depreciation of the high-yielding currency and an appreciation of the low-yielding, or funding, currency. Early work on foreign exchange markets appeared to find a "forward-rate bias." If you held on to a high-yielding currency long enough, the combination of the rate differential and currency movements would still put you in the money. This is a result of the presence of a risk premium for holding the volatile assets of countries perceived to be risky, but you are only able to earn this premium if you are an expert at market timing or indifferent to the intervening periods of bankruptcy and panic.
Understanding Risk Appetite
Though there are times it may look like it, international capital flows are not a simple story of positive rate differentials leading to stronger currencies and lower rate differentials leading to weaker currencies. In that story domestic monetary policy is king and the removal of capital controls makes sense. Over 20 years of analyzing and trading foreign exchange markets has taught me that to make sense of what happens, it is important to overlay onto the power of interest rate differentials, the periodic shifts in international investors’ appetite for risk and the market’s categorization of emerging economy currencies as risky and a few others as safe.
There are times, most of the time in fact, when investors have a high appetite for risk and they chase after yields—any yield. In these circumstances, higher domestic interest rates to curb an overheating economy causes the currency to appreciate and import prices to drop, but the resulting capital inflows into local banks keep bank lending high, stoking up the non-tradable part of the economy further, drawing in more capital inflows. Reducing the rate differential does not easily tame capital inflows. In an environment of high-risk appetite, the equation is not just about rate differentials. When a currency or other asset markets have developed an upward momentum, dragging along a story of economic renaissance, interest rates need to be cut to far below what may be appropriate for the domestic economy before capital flows reverse.
In periods of risk aversion, when stories of gloom and doom prevail, raising interest rates in the countries with risky currencies does not draw in capital flows. If they are seen to potentially undermine the local economy, outflows could even accelerate, driving the currency down in a vicious cycle. In these periods, safe havens receive an uncontrollable amount of returning capital that spurs further inflows. No level of lower interest rates can arrest the flow as Switzerland, Germany, and the United States have discovered. International capital flows come in only two modes: feast or famine. Rate differentials play a role, but the story is really one of a loss of control of monetary policy. It is a loss of control that is acute the more open the economy is and the more movements in currencies and capital flows can overwhelm a domestic economy. It is far less acute for the larger economies like the United States or Europe that are the subject of most economic analysis.
International Policy Responses
There is a long history of policy response to this problem. Capital controls were an early response. However, for a number of reasons the removal of capital controls became a common policy prescription of the Washington-based multilateral institutions. Over time capital flows grew large and these same institutions were overwhelmed by international financial crises. In the debris of these crises, these Washington-based institutions demanded the kind of austerity policies they have warned against in European and other advanced economies as the pre-condition for any international assistance. Consequently, many countries decided to adopt a policy mix of stable exchange rates and high levels of reserves.
The period of reserve accumulation for emerging economies, essentially the first decade of the new century, was associated with stronger economic growth than before, perhaps because heavier reserves weighed down the risk premium. In the subsequent period of international crisis, 2008–12, those with substantial reserves fared better than others. The lessons that emerging countries with high reserves drew from the experience of this policy mix are that it allowed them to better weather the most recent capital storms than in the past and came with limited economic cost.
However, this is not the lesson drawn in the advanced economies. There, reserve accumulation is described as a savings glut—essentially an economic recession story—that held down US policy and market interest rates. The narrative in the United States is that it was this recession-inducing international savings glut—not expensive US-led wars; the George Bush tax cuts; low US, European, and Japanese interest rates; and demand for long-term assets by pension funds or US and European regulatory lapses—that caused the asset market boom that led to the bust. Consequently, there is strong pressure from the Washington-based institutions to move away from managed exchange rates and high reserves. This takes the form of proposals from the United States and elsewhere that surplus countries should pay a tax or something similar to encourage them to appreciate their currencies or spend their surpluses domestically, but it also includes a less critical view of capital controls.
There has been much experience of capital controls. While the experience in terms of economic growth is less restrictive than often recalled, they pose plenty of challenges, such as the discrimination between tradable and non-tradable sectors of the economy, potential reduction in investment and competitive pressures in smaller economies and the need to continuously update controls to limit avoidance that is mostly afforded by the wealthy and politically connected. Macroprudential tools may represent a more flexible, less discriminatory alternative to capital controls. Raising local bank capital-adequacy requirements and requiring lower loan-to-value ratios when lending growth rises above a certain threshold, and doing the opposite when lending growth drops, could help to address the flood or drought of capital without discriminating against the tradable sectors or even foreign versus local capital. If these macroprudential tools temper the cycle of returns, they may also have an impact on the volatility of international capital flows and the exchange rate. They can even be targeted at certain sectors to smooth out distortions caused by having a single high interest rate across an economy to deal with a boom in just one part of the economy like housing.
It is likely that the strong tides of investor risk appetite would be more than a match for these controls, but even in these circumstances these tools will serve to build up capital buffers in the boom that may help the banks better manage the busts. Another type of macroprudential policy that could dampen the impact of the risk appetite cycle is to require long-term lenders to have long-term funding, whether local or foreign. This could be done with the proposed stable funding ratios proposed by Basel or additional capital-requirements for maturity mismatches. The channel by which the sudden reversal of investor risk appetite destabilizes an economy is the maturity mismatch between long-term domestic lending that is funded by short-term foreign borrowing. Everyone now talks about the need for a more macroprudential approach to regulatory policy and a framework is now in place, but public utterances are not yet matched by the intensity of the use of macroprudential tools. If more were done, a number of problems could be addressed more directly than the indirect and second-best use of exchange and capital controls.