The United States needs to open up dollar swap lines to emerging-market central banks to lessen the risk of a liquidity crunch amid collapsing commodity prices.
That was the main takeaway from IMF managing director Christine Lagarde’s speech at the University of Maryland on Thursday. Ms Lagarde did not single out the US when she called for an “adequate global financial safety net”, of which new swap lines would form the most important part.
But more than 60 per cent of global foreign exchange reserves are held in dollars, while dozens of countries, including the Arabian Gulf nations, peg their currencies to the dollar.
When foreign currency runs out, financial institutions find themselves unable to meet their obligations, and trade dries up. Egypt, whose economy has suffered as the government creates dollar shortages by defending an overvalued exchange rate, is an example of how damaging currency shortages can be to the real economy.
The US does not have swap lines with many of the central banks of emerging-market countries pegged to the dollar. This means that the ability of emerging-market economies to respond to financial shocks is limited by their stock of foreign reserves.
In good economic times, this is not a problem. But with the commodities slowdown depriving exporters such as Nigeria of their main source of foreign exchange, the inability of the government to obtain dollars from the US could worsen a liquidity crunch.
Ms Lagarde also called for better regulation of capital flows between advanced economies and emerging markets.
About $531 billion of capital flowed out of emerging markets last year, compared to a net inflow of $48bn in 2014. That can be a major blow to economies with large debt piles, which now find demand for debt drying up, raising the cost of servicing it and threatening its sustainability.
The Greek crisis is a simple example of how hot money flows in a country with a fixed exchange rate can be destructive as well as beneficial. In the years up to 2008, capital flowed into the country, which offered higher returns than anywhere else in the euro zone.
But when the financial crisis hit, investors fled Greece en masse. That left Greek banks insolvent, led the state to socialise their debt and left the Greek government with a massive debt burden. EU-imposed austerity then made this debt burden even more difficult to pay off.
Effective regulation of capital flows is exceptionally difficult, however. Capital controls usually make investment flows less efficient, without reducing their volatility. A better solution may be to abandon fixed exchange rates when capital flows become volatile – the Gulf, which is not a major recipient of foreign direct investment, is unlikely to face this particular problem.
Ms Lagarde also called for governments to look at the tax deductibility of interest payments, to encourage more investment in equity rather than emerging market debt.
“There are no easy answers”, she said. The worry is that the emerging market debt pile becomes an emerging market debt crisis. If so, Ms Lagarde will be especially busy over the coming year.
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