Central banks in emerging markets and smaller developed nations should use tools such as stress tests and leverage ratios to smooth disruptions caused by capital flows rather than blame larger countries, according to Helene Rey, a professor of economics at London Business School.
“There is a potent global financial cycle in gross capital flows, credit creation and asset prices, which has tight connections with fluctuations in uncertainty and risk aversion,” Rey said in a paper presented today at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming. “Independent monetary policies are possible if and only if the capital account is managed, directly or indirectly via macroprudential policies.”
Rey said “non-central countries” should use such measures to establish their independence. The most appropriate ways to address the dilemma of managing capital flows are “probably to take actions directly aimed at the main source of concerns” such as excessive leverage and credit growth, she wrote in the paper.
The $3.9 trillion of cash that flowed into emerging markets over the past four years has started to reverse since Federal Reserve Chairman Ben S. Bernanke in June talked about potentially tapering his third round of so-called quantitative easing this year.
It’s not practical for countries around the world to coordinate their policies on “monetary spillovers” because such cooperation may conflict with domestic central-bank mandates, such as inflation targets, said Rey, who this year became the first woman to win the Yrjo Jahnsson Prize, given to European economists under the age of 45 whose research is significant to Europe.
Emerging markets from Brazil to Indonesia have raised borrowing costs in 2013 to try to aid their currencies as the prospect of reduced U.S. monetary stimulus curbs demand for assets in developing nations.
The Fed’s second round of so-called quantitative easing, announced in November 2010, sparked complaints from officials in Germany, China and Brazil that the U.S. was starting a competitive devaluation of the dollar, hurting their economies. Bernanke responded by saying the Fed must focus on domestic growth.
“The management of aggregate demand in systemically important economies has important consequences for economic activity in the rest of the world,” Rey wrote. “This is a major consideration. The rest of the world cannot at the same time complain of excessive capital inflows due to loose monetary policy in the center countries and wish for a higher level of economic activity and demand stimulus in the same countries.”
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