There’s a decent case to make that we might be approaching a world in which policymakers start to restrict the movement of capital in just the same way that they are restricting the movement of people and goods. Experiments with capital controls, in other words, are probably a step closer to us.
Of course, capital wants to flow across borders to find higher returns than it can find at home, or to diversify a portfolio’s risks. But with the global economy in a state of potential collapse, the uncertainty around expected returns is too high for almost any kind of investor to bear. And if investors don’t have any appetite for risk at all, then flows aimed at diversifying those risks will tend towards zero. It is for that reason that, just as people are going home and staying home, capital is too.
By some accounts, the outflow from emerging markets bond and equity funds in the past two weeks has been close to 4% of net asset value. This represents a bigger withdrawal of funds than at the same stage of either of the past two crisis-episodes for capital flows to emerging economies: the May 2013 Taper Tantrum and the September 2008 collapse of Lehman Brothers. In other words, the withdrawal of funding from emerging economies that’s now taking place may be unprecedented. In a rush for the relative safety of dollar cash or equivalent, asset prices and currencies in emerging markets might continue to look highly vulnerable.
It is rational for a policymaker to sell reserves and allow the currency to lose value if the underlying cause of the capital outflow might soon disappear. If the expected value of future net capital inflows remains positive, it makes sense to keep selling dollars today. But policymakers, like the rest of us, know nothing about when COVID-19 will end. And so their willingness to keep selling dollars to fleeing investors, both domestic and foreign, could run out.
That is particularly true because of a contradiction that is emerging between risk and risk premium, which in some ways are moving in opposite directions to each other. Protecting the domestic economy might require lower rates, but protecting the capital account – in other words, preventing large capital outflows – might require higher rates, especially if debt burdens are rising.
The only way to resolve this contradiction, in principle, is to close the capital account. One extreme form of closing the capital account is, of course, default on external debt. But default is not the only way to conserve foreign exchange. Efforts to put up ‘gates’ on domestic banks’ ability to sell dollars to their clients – through taxes, differential exchange rates, or outright bans – could become more visible. One obvious way of supporting the international monetary system now would be a large creation of Special Drawing Rights (SDRs) to increase global liquidity well beyond the $1 trillion of lending capacity that the IMF currently has (which, by the way, includes $200 billion of lending commitments the Fund has already made).
Things might change in the coming weeks. But as things stand, the longer the virus stays with us, the more capital mobility across emerging markets might be threatened.