G-20 Focus: What Asian Nations Can Do About QE2

The G-20, consisting of economic representatives from the world's 19 biggest national economies and the European Union, has kicked off its meeting in Seoul, South Korea. Even before the meeting began, there was much complaining about the U.S. Fed's $600 billion quantitative easing program (QE2), and worries about the rapid flow of world capital into emerging markets. Some Asian nations are contemplating new capital controls, though it's not clear they will work.

The QE2 plan is drawing fire because it is viewed by many as an attempt to devalue the dollar even further relative to the world's currencies. A weaker dollar makes U.S. exports more competitive in global markets, since U.S. firms can charge lower prices.

The plan's detractors don't seem to appreciate that the QE2 Treasury bond purchases weren't set in motion with the intent of setting the world's economic teeth on edge. Rather, Fed Chairman Ben Bernanke chose this path because he had no better options left for stimulating the U.S. economy, and he feared the possibility of Japanese-style deflation taking hold if he failed to act.

In response to QE2, the world's rapidly growing economies would love to devalue their currencies to keep up -- or down -- with the U.S. But they can't, thanks to fast money that's flowing into their countries and pushing up prices. Those governments are also worried about the bust that will inevitably follow when that fast money heads for the exits all at once.

That pattern of fast money flows followed by a bust is what drove Iceland from boom to bust over the course of a few years, as described in my book, Capital Rising: How Global Capital Flows Are Changing Business Systems All Over the World, co-authored with Srini Rangan. Iceland's banks attracted deposits from around the world by raising the rates they paid depositors. When the financial crisis hit in September 2008, those foreign capital providers wanted to get their money out fast, which led to the collapse of Iceland's banking system.

Follow the Money, and See What It's Following

Now we're seeing similarly rapid capital inflows elsewhere, but for different reasons. Instead of flowing toward higher deposit rates, capital is pouring into developing countries in search of rapid economic growth. Bloomberg reports that Asia has attracted "$2.3 billion of capital daily since April 2009." Short-term capital investment in emerging markets should hit $458 billion in 2010, the highest level since 2007's $784 billion, according to the Institute of International Finance.

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And it's worth noting that many Asian stock markets -- those in India, Indonesia, Malaysia, and the Philippines -- have hit record highs.

Meanwhile, the MSCI Emerging Market Asia Index of stocks has climbed 17% in 2010 -- nearly twice the S&P 500's 9% rise. And with the exception of the Hong Kong dollar, which is pegged to the dollar, all the major Asian currencies have strengthened, which is making it harder for those countries to boost their exports, according to Bloomberg.

While the affected countries might want to raise interest rates to control the inflation that results from all the foreign capital flow, they are caught in a catch 22: If they did so, they fear that those higher interest rates would attract even more capital by making the so-called carry trade -- borrowing money in a cheap currency to buy a higher-yielding currency -- even more profitable than it already is.

In light of all this, some countries are starting to impose capital controls, among them:

• Thailand last month removed a 15% tax exemption for foreigners on income from domestic bonds. And on Oct. 29, Thai central bank Governor Prasarn Trairatvorakul said "he wouldn't rule out controls if the baht's appreciation accelerates," according to Bloomberg.

• South Korea is considering a bank tax and a tax on financial transactions, and its central bank Governor Kim Choong Soo said capital controls may be "useful."

• Indonesia may extend a holding period for foreign purchases of its central bank notes from one to three months, reports Bloomberg.

• In China and Taiwan, regulators are imposing fresh restrictions on stock market investments by foreigners, and Brazil has "twice raised taxes on foreign investors." according to The New York Times

High-Growth Markets Remember a Painful Economic Lesson

These countries are no doubt worried about a rerun of the 1997 Asian financial crisis that sent many of them into a lengthy economic tailspin. According to the Congressional Research Service, that economic meltdown led to rapid plunges in Asian stock markets and the failure of many of their leading financial institutions.

The cause was two rounds of currency depreciation that had been occurring since early that summer. The first round was "a precipitous drop in the value of the Thai baht, Malaysian ringgit, Philippine peso and Indonesian rupiah. As those currencies stabilized, a second round began with downward pressures hitting the Taiwanese dollar, South Korean won, Brazilian real, Singaporean dollar, and Hong Kong dollar."

Their governments responded to the resulting currency weakness by raising interest rates and selling their foreign exchange reserves. This put the brakes on economic growth and sucked capital out of equities into interest-bearing securities. The parallel currency crises also revealed severe problems in their banking and financial sectors.

Two Better Ways to Avoid a Crisis

Naturally, those countries aren't eager to relive that agony. To avoid it, they can do two things: Keep plenty of dollars and euros in reserve in their central banks, and be more disciplined about the kinds of companies that get listed on their stock exchanges. The reason for the first recommendation is that such currency reserves will help the countries if capital flows out fast. That's what Iceland's central bank should have done, but it didn't, so when the nation's banking system collapsed, its kronurs, the Icelandic currency, were insufficient to repay Iceland's obligations.

The reason for the second recommendation is that -- with apologies to Warren Buffett -- when the tide goes out, you can see who's wearing a bathing suit and who's not. Simply put, investors are more likely to stick with investments in companies with exciting financial prospects than ones that are doing poorly.

At this point, it is probably too late for those nations to do anything about the second recommendation, but it's not too late to work on the first one.