The most controversial consequence of the US Federal Reserve’s quantitative easing is the impact this increase in liquidity has had on 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 Brazilian real, then shorting the dollar and going long on the real.
Brazil directly blamed the flood of hot money for the 40% appreciation of the real between 2009 and 2011. Brasília saw the rise in the value of the currency, which increased the cost of its exports, as 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 nonresident 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 FX spot markets.
Many financiers cried foul, complaining that Brazil was subverting free-market forces and 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 policy stance and Brazil maintained its interventions, only lessening the regulation – the IOF financial operation 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, by Brittany Baumann and Kevin Gallagher – set out to find how effective these measures had been. It contrasted Brazil’s macro-prudential measures with Chile’s 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 faced with hot financial inflows from the developed markets are considerable.
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, being effective only at the time of announcement and were offset by regulations to the American depositary receipt market. In comparison, Chile’s intervention had no statistically substantial 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 have long 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 – as in the 1960s and 1970s – it would have been more effective at keeping capital at home, doing what it was presumably intended to do: providing liquidity for productive and employment-based growth.
Without exit taxes, the quantitative easing measures, 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?