Probably the most controversial consequence of the US Fed’s programme of quantitative easing has been the impact that this increase in liquidity has had for emerging markets. With very low interest rates in the US (and elsewhere) investors sought short-term investment in countries with high real interest rates. Investors also played the carry trade, borrowing dollars to buy the Real, then shorting the dollar and going long on the Real.
Brazil directly blamed what it called the “Tsunami” of hot money for the 40% appreciation of the Real between 2009 and 2011. Brasília saw the rise in the value of the currency, increasing the cost of its exports, making the country’s manufacturing sector less competitive internationally, and, it believed, suppressing the country’s economic growth. It responded with a series of capital controls, taxing non-resident equity and fixed-income portfolio flows. It also taxed margin requirements of foreign exchange derivatives transactions and required a non-interest reserve requirement for banks’ short dollar positions in the foreign exchange spot markets. Many financiers cried foul, complaining that Brazil was preventing free market forces, that it was distorting the market and that it wouldn’t work – worse, it was counter-productive. Despite the lobbying, the IMF gave moral support to Brazil’s aggressive policy stance and Brazil maintained its interventions, only lessening the regulation (the IOF tax on foreign equity investments was the first plank to be dismantled in December 2011) when the Real devalued.
A research report published in June “Navigating Capital Flows in Brazil and Chile”, written by Brittany Baumann and Kevin Gallagher, set out to find out how effective these measures had been. It contrasted Brazil’s ‘macro-prudential’ measures with Chile’s more straightforward policy of buying dollars, a strategy it initiated in January 2011 in response to the appreciation of its currency. Its findings are interesting and, while the issue is moot to Brazil today, with the Real trading in a Brasília-friendly band of between $2.00 and $2.10, the implications for future foreign exchange policy of emerging markets that are faced with hot financial inflows from the developed markets are significant.
In short, the paper finds that Brazil’s series of capital controls worked. To an extent – the mixed-metaphor the authors use is “helping Brazil lean into the wind rather than reversing the tsunami”. Capital controls altered the composition of inflows from the short to the longer-term. They had a lasting impact on the level and volatility of the exchange rate and improved Brazil’s ability to pursue an independent monetary policy. In terms of asset prices the measures were less successful, only being effective at the time of announcement and were offset by regulations to the ADR market. In comparison, Chile’s intervention had no statistically significant impact on total inflows or the composition of these inflows.
So a policy ‘win’ for Brasília. But the report posits a more intriguing question for Washington. Economists dating back to Keynes have argued that controls such as these only really work when applied to both ends of the transaction. Brazil’s actions cooled the flows a bit, but if the US had outflow tax (like it had in the 1960s and 1970s) it would have been more effective at keeping this capital at home, doing what it was presumably intended to do: namely providing liquidity for productive and employment-based growth. Without exit taxes, the QEs, which were designed to give the financial breath of life to the zero-interest patient, drained away to high real interest markets overseas.
If, as this report has shown, targeted policy intervention can be effective in managing the excesses of free market forces, does not the US have both an economic interest and a moral obligation to constrain QE liquidity to its domestic markets?