NATHAN GARDELS: What does the reverse flow of capital out of the emerging markets back to the advanced economy due to Fed “tapering” mean for global growth?
MOHAMED EL-ERIAN: Much depends on why the Fed is tapering.
It would be good news for global growth if the Fed is tapering for “good” reasons – meaning that the central bank has strong reasons to believe that the US economy is approaching “escape velocity.” In such circumstances, the taper would signal that, after too many years of sluggish growth, the US is resuming its role as an engine of global growth.
But the Fed could also taper for “bad” reasons – that is to say that its prolonged experimentation with unconventional monetary policy threatens to create too much collateral damage and unintended consequences. In these circumstances, the taper, which involves reduced Fed support for markets and the global economy, would indicate growing policy effectiveness.
This fundamental distinction is important, as global markets will likely amplify whatever signals come out of the Fed.
In most likelihood, the Fed will taper for a mix of reasons. Specifically, it will likely be comforted by the notion that the American economy continues to heal, but frustrated by the gradualism of the recovery and the threat of collateral damage.
GARDELS: How much was the emerging economy’s development due to this cheap money? What must they do to sustain growth in the absence of low Fed rates?
EL-ERIAN: It is difficult to know for sure. Our evaluation is that the “emergence,” as you call it, has had a lot more to do with the policies implemented over the years by emerging economies and less with the monetary policy stance in advanced countries.
For some emerging economies, the Fed’s experimental policy stance has constituted a headache from day one. And countries like Brazil have been quite vocal in expressing concerns.
By venturing deeper into experimental monetary policy territory and staying there for longer, the Fed contributed to cross-border surges of private capital, which overwhelmed some emerging economies’ ability to absorb the inflows productively. This weakened the domestic financial intermediation process in these emerging economies, caused an excessive appreciation in the currency, and created pockets of financial vulnerability. Now, with talk of Fed tapering, the capital flow has reversed violently, causing another set of instabilities.
GARDELS: When the rest of the world says the US should “calibrate” its interest rate climb with others' interests in mind, what can that mean practically?
EL-ERIAN: It is a broader issue that reflects the highly interconnected nature of today’s global financial system.
Whether it is Japan or the United States, you will hear officials there say that they are pursuing domestic objectives using domestic tools. They will argue that a healthy domestic economy contributes to the global well-being. And, if pushed further, they will state that they are legally required to adopt a domestic focus.
These characterizations, though strictly correct, are overly narrow given cross-border linkages. Simply put, neither Japan nor the US can – for the well-being of their own citizens – ignore the international feedback loops triggered by their policy actions.
As an example, consider how the recent taper-induced dislocations in emerging economies can impact advanced countries.
The sudden flow of private capital out of emerging economies and its cascading disruptions will likely undermine demand there, be it consumption or investment. This would translate into lower revenues for the many American companies that have relied on growing sales to the emerging world, thus limiting their employment and investment plans.
Then there is the financial transmission channel. The more emerging economies use their international reserves to limit the volatility in their currencies, the less they buy in US Treasuries. In turn, this contributes to the upward movements in US borrowing costs, including on mortgages that Americans rely on to purchase new homes or refinance existing debt.
The challenges are compounded by the absence of an effective global policy conductor.
This role should be performed by the International Monetary Fund. But its effectiveness is undermined by long-standing representation and governance deficits. For its part, the G7 has a composition that is no longer reflective of the economic-power realities of today’s global economy. And the G20, while much more representative, lacks as yet sufficient institutional robustness and continuity.
GARDELS: Will the $100 billion BRIC (Brazil, Russia, India, and China) fund – a kind of BRIC IMF – have any impact? Is it the birth of an alternative IMF?
EL-ERIAN: No, at least not as yet. There are still lots of legal and operational details to sort out before such a fund can be fully effective, let alone play the role of an alternative IMF.
Mohamed El-Erian is the CEO of the investment firm PIMCO, the world’s largest bond investor.
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