How Emerging Markets Can Avoid Getting Burned by Hot Money

hot money
hot money

Nobel Prize-winning Columbia University economist Joseph Stiglitz fears the dangers of capital flowing into emerging markets. He has a point about the dangers of such flows, but he underemphasizes their benefits. Still, countries need to protect themselves against the risks while profiting from the dangers. But how?

Three ways: Give capital providers a chance to earn long-term profits, don't get too dependent on them and prepare for their departure.

Stiglitz gave a speech on Dec. 10 in Chile suggesting that the country would be vulnerable as U.S. investors shovel a good chunk of the $600 billion in cash from the Fed's so-called QE2 into faster-growing emerging markets like Chile, whose GDP is forecast to grow by 6% in 2011. As I posted on DailyFinance, Stiglitz is certainly right about the flow of capital to emerging markets: They're expected to rise 42% to $825 billion by the end of 2010 compared to the previous year.

Stiglitz also warned Chile that such capital inflows could boost the value of its currency -- its peso is up 6.6% in 2010 relative to the dollar -- making it more difficult for Chile to export its goods to countries with weaker currencies. He noted that in October, Brazil introduced a big increase in a tax on foreigners' fixed-income purchases to 6%, triple 2009's level. The effect of that tax increase was to tamp down Brazil's currency because a rapid rise in its value would have made it more difficult for Brazil to export..

Copper and China and Chile

But when it comes to Chile, I'm not sure whether Stiglitz's warnings are on target. After all, copper is Chile's biggest export, and China is its biggest importer. As long as China -- with 2010 GDP of $5.7 trillion -- keeps growing at its current rate of around 10%, its demand for Chilean copper through state-owned copper company, Codelco, is likely to persist.

If China sustains that growth rate, it'll be the world's largest economy a mere decade from now -- with GDP of $21.6 trillion by 2020. Since China will need Chile's huge copper deposits more than ever, I doubt Beijing will care about Chile's modest currency appreciation.

Unlike Brazil, Chile -- which benefits handily from China's growth -- has so far resisted calls to introduce barriers to global capital flows. And it's not alone. India also doesn't see dangers in global capital inflows. A recent report in The New York Times explains that India welcomes foreign money and is letting its rupee rise -- despite the challenges that creates for exporters, such as its textile industry. The higher rupee, however, helps boost Indian consumer purchasing power and provides the money to build domestic retail space, hotels, offices and condominiums.

India is betting that a rising rupee won't hit its higher-value exports -- such as information technology services and pharmaceuticals -- as hard as it will textiles. Ultimately, this will mean India has to exit industries where customers buy based on having the world's lowest price and invest in industries where customers buy based on high quality.

Beware of Hot Money

The biggest danger of global capital flows is what happens when the money leaves suddenly. As I described in my book, Capital Rising: How Global Capital Flows Are Changing Business Systems All Around the World, co-authored with Srini Rangan, global capital flowing into high-yielding bank deposits and real estate development is often "hot money" that will flee when financial troubles appear.

That's what happened to Iceland in 2008. Landsbanki, then one of Iceland's biggest banks, attracted $7 billion to its IceSave accounts from 300,000 British retail investors. To pay the higher rates that attracted the Brits, Iceland's banks lent out those deposits to risky projects around the world, which paid even higher interest rates.

But with the global financial crisis beginning in September 2008, those hot-money investors got nervous and started withdrawing their capital. Iceland's banks suffered a cash crunch, leading ultimately to the Icelandic government nationalizing them.

Iceland Missed Opportunities to Protect Itself

Chile, India and other emerging nations that enjoy the benefits of foreign capital flows must protect themselves by keeping their reserves in a currency that's likely to hold its value in the event that the capital leaves the country suddenly. Iceland, unfortunately, kept its reserves in its own currency, the krona, whose value plunged as the foreign capital fled.

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Iceland should have anticipated that possibility and hedged its reserves. It also should have created incentives for that capital to find its way into longer-term investments such as startups and financing big-company operations.

So, Stiglitz is right that emerging-market capital flows can be risky for their recipients. Indeed, a major slowdown in China's growth rate would have serious repercussions for countries like Chile and Australia that are cruising on China's demand for commodities.

But as the cases of India and Chile demonstrate, those flows can also help create valuable companies that hire people and pay taxes. The trick for emerging nations is to take steps to protect themselves against the risks of capital flows while welcoming the benefits.