HT PAREKH FINANCE COLUMN

Dampening the Global Risk

Appetite Cycle
Using Macro-prudential Tools
Avinash Persaud

International capital flows come

in only two modes: feast or
famine. The policy response to
both situations has been primarily
via exchange and capital
controlsboth have their
consequences. Macro-prudential
tools may represent a more
flexible, less discriminatory
alternative to capital controls.
These tools of macroeconomic
policy, though already in place,
are not used as they should be,
that is, to directly address
the risk-appetite cycle
of international capital.

arket participants and readers

of the financial press will be
familiar with the carry trade
in global foreign exchange markets. This
is where, in the absence of exchange
controls, a speculator borrows a currency
with a low interest rate and deposits it in
the currency with a high interest rate.
The speculator benefits if the currency
with the high interest rate does not
depreciate by the same percentage of the
interest rate differential or what is
referred to as the carry. The weight of
many traders pursuing the carry often
lifts the high-yielding currency and so
the speculator gets the benefit of being
paid for holding on to an appreciating
asset. Part of the appeal of the carry
trade for traders is that it is both selffulfilling and it appears to resonate with
international macroeconomic theory,
where tighter monetary policy leads to a
currency appreciation.
Speculation and Carry Trade

Avinash Persaud (profadpersaud@gmail.com)

is non-resident senior fellow, Peterson Institute
for International Economics in Washington
and Chairman of Elara Capital of London and
Mumbai.

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Speculation is a pejorative word in many

circles, especially in the central banks of
emerging economies. In some countries
they used to be shot. The idea that a certain amount of speculation helps to oil
markets and supports the arrival of the
right price is a modern one, and outside
of the United States (US) and a few other
places, it is confined to textbooks. In
these textbooks, the higher interest rate
of one currency merely compensates
holders for a future depreciation of that
currency. When a country tightens monetary policy, the exchange rate overshoots its long-run level to a point from
where it will steadily depreciate by the
amount of the interest rate differential,
which helps to explain the large amount
of volatility in floating exchange rates.

Rudi Dornbusch should have won the

Nobel Prize for his overshooting theory
if just for the reason that he was one of a
disappearing sort of economist, who tried
to fit theory to observations rather than
trying to fit the world to theory. The
essential point is that in currency markets, the interest rate premium is not a
speculators free lunch, but compensation for taking a real risk.
Over some period of time then, the
carry trade ceases to work, perhaps
because of an adverse economic or
political surprise, or perhaps the weight
of carry trades had previously pushed
the currency over what later emerged as
its fundamental value by more than the
rate differential. When carry trades begin
to submerge, the simultaneous bailing
out of these trades can lead to a sharp
depreciation of the high-yielding currency
and an appreciation of the low-yielding,
or funding, currency. Early work on foreign exchange markets appeared to find
a forward-rate bias. If you held on to a
high-yielding currency long enough, the
combination of the rate differential and
currency movements would still put you
in the money. This is a result of the presence of a risk premium for holding the
volatile assets of countries perceived to
be risky, but you are only able to earn
this premium if you are an expert at
market timing or indifferent to the intervening periods of bankruptcy and panic.
Understanding Risk Appetite
Though there are times it may look like
it, international capital flows are not a
simple story of positive rate differentials
leading to stronger currencies and lower
rate differentials leading to weaker currencies. In that story domestic monetary
policy is king and the removal of capital
controls makes sense. Over 20 years of
analysing and trading foreign exchange
markets has taught me that to make
sense of what happens, it is important to
overlay onto the power of interest rate
differentials, the periodic shifts in international investors appetite for risk and
the markets categorisation of emerging
economy currencies as risky and a few
others as safe.

NOVEMBER 7, 2015

vol l no 45

EPW

Economic & Political Weekly

HT PAREKH FINANCE COLUMN

There are times, most of the time in

fact, when investors have a high appetite
for risk and they chase after yieldsany
yield. In these circumstances, higher domestic interest rates to curb an overheating
economy causes the currency to appreciate and import prices to drop, but the
resulting capital inflows into local banks
keep bank lending high, stoking up the
non-tradable part of the economy further,
drawing in more capital inflows. Reducing the rate differential does not easily
tame capital inflows. In an environment
of high-risk appetite, the equation is not
just about rate differentials. When a currency or other asset markets have developed an upward momentum, dragging
along a story of economic renaissance,
interest rates need to be cut to far below
what may be appropriate for the domestic economy before capital flows reverse.
In periods of risk aversion, when stories of gloom and doom prevail, raising
interest rates in the countries with risky
currencies does not draw in capital flows.
If they are seen to potentially undermine the local economy, outflows could
even accelerate, driving the currency
down in a vicious cycle. In these periods,
safe havens receive an uncontrollable
amount of returning capital that spurs
further inflows. No level of lower interest
rates can arrest the flow as Switzerland,
Germany and the US have discovered.
International capital flows come in only
two modes: feast or famine. Rate differentials play a role, but the story is really
one of a loss of control of monetary policy. It is a loss of control that is acute the
more open the economy is and the more
movements in currencies and capital
flows can overwhelm a domestic economy. It is far less acute for the larger
economies like the US or Europe that are
the subject of most economic analysis.
International Policy Responses
There is a long history of policy response
to this problem. Capital controls were an
early response. However, for a number
of reasons the removal of capital controls
became a common policy prescription of
the Washington-based multilateral institutions. Over time capital flows grew
large and these same institutions were
overwhelmed by international financial
Economic & Political Weekly

EPW

NOVEMBER 7, 2015

crises. In the debris of these crises, these

Washington-based institutions demanded the kind of austerity policies they
have warned against in European and
other advanced economies as the precondition for any international assistance.
Consequently, many countries decided
to adopt a policy mix of stable exchange
rates and high levels of reserves.
The period of reserve accumulation
for emerging economies, essentially the
first decade of the new century, was
associated with stronger economic growth
than before, perhaps because heavier
reserves weighed down the risk premium. In the subsequent period of international crisis, 200812, those with substantial reserves fared better than others. The lessons that emerging countries
with high reserves drew from the experience of this policy mix are that it allowed
them to better weather the most recent
capital storms than in the past and came
with limited economic cost.
However, this is not the lesson drawn
in the advanced economies. There, reserve
accumulation is described as a savings
glutessentially an economic recession
storythat held down US policy and
market interest rates. The narrative in the
US is that it was this recession-inducing
international savings glut, not expensive
US-led wars, the George Bush tax cuts, low
US, European and Japanese interest rates,
and demand for long-term assets by pension funds or US and European regulatory
lapses that caused the asset market boom
that led to the bust. Consequently, there
is strong pressure from the Washingtonbased institutions to move away from
managed exchange rates and high
reserves. This takes the form of proposals
from the US and elsewhere that surplus
countries should pay a tax or something
similar to encourage them to appreciate
their currencies or spend their surpluses
domestically, but it also includes a less
critical view of capital controls.
Macro-prudential Tools
There has been much experience of capital controls. While the experience in terms
of economic growth is less restrictive
than often recalled, they pose plenty of
challenges, such as the discrimination
between tradable and non-tradable
vol l no 45

sectors of the economy, potential reduction in investment and competitive pressures in smaller economies and the need
to continuously update controls to limit
avoidance that is mostly afforded by the
wealthy and politically connected. Macroprudential tools may represent a more
flexible, less discriminatory alternative
to capital controls. Raising local bank
capital-adequacy requirements and requiring lower loan-to-value ratios when
lending growth rises above a certain
threshold, and doing the opposite when
lending growth drops, could help to
address the flood or drought of capital
without discriminating against the tradable sectors or even foreign versus local
capital. If these macro-prudential tools
temper the cycle of returns they may
also have an impact on the volatility of
international capital flows and the
exchange rate. They can even be targeted at certain sectors to smooth out
distortions caused by having a single,
high, interest rate across an economy to
deal with a boom in just one part of the
economy like housing.
It is likely that the strong tides of
investor risk appetite would be more
than a match for these controls, but even
in these circumstances these tools will
serve to build up capital buffers in the
boom that may help the banks better
manage the busts. Another type of macroprudential policy that could dampen the
impact of the risk appetite cycle is to
require long-term lenders to have longterm funding, whether local or foreign.
This could be done with the proposed stable funding ratios proposed by Basel or
additional capital-requirements for maturity mismatches. The channel by which
the sudden reversal of investor risk appetite destabilises an economy is the maturity mismatch between long-term domestic
lending that is funded by short-term
foreign borrowing. Everyone now talks
about the need for a more macroprudential approach to regulatory policy
and a framework is now in place, but
public utterances are not yet matched by
the intensity of the use of macro-prudential tools. If more were done, a number
of problems could be addressed more
directly than the indirect and second-best
use of exchange and capital controls.
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