SINGAPORE (April 7): With many countries, including Singapore, going into lockdowns of various extent, the flow of goods, people across borders have clearly been stifled. Policymakers might now be tempted to exercise some form of capital controls, warns Citi’s head of emerging markets economics, David Lubin.
“Experiments with capital controls, in other words, are probably a step closer to us,” writes Lubin in a research note on April 2.
Normally, capital has this natural propensity to move from one market, to another, as the owners seek either higher returns, or, to diversify risks. With the Covid-19 outbreak leading unprecedented economic shock, the uncertainty around expected returns is too high for almost any kind of investor to bear.
“And if investors don’t have any appetite for risk at all, then flows aimed at diversifying those risks will tend towards zero. It is for that reason that, just as people are going home and staying home, capital is too,” reasons Lubin.
He observes that the outflow from emerging markets bond and equity funds in the past fortnight has been close to 4% of net asset value, which represents a bigger withdrawal of funds than at the same stage of either of the past two crisis-episodes for capital flows: the May 2013 Taper Tantrum and the September 2008 collapse of Lehman Brothers.
This implies that the withdrawal of funding from emerging economies now may be unprecedented, adding to the vulnerability of asset prices and currencies of emerging markets.
The playbook for policymakers is to sell reserves and allow their currencies to lose value if the underlying cause of the capital outflow might soon disappear. Now, if the expected value of future net capital inflows remains positive, then, it makes sense to keep selling dollars today.
“But policymakers, like the rest of us, know nothing about when COVID-19 will end. And so, their willingness to keep selling dollars to fleeing investors, both domestic and foreign, could run out,” says Lubin.
There is this inherent dichotomy between protecting the domestic economy with lower rates, but, protecting the capital account – in other words, preventing large capital outflows – might require higher rates, especially if debt burdens are rising, says Lubin. Thus, the only way to resolve this contradiction, in principle, is to close the capital account, he suggests.
According to Lubin, one extreme form of closing the capital account is to default on external debt. However, a default is not the only way to conserve foreign exchange. “Efforts to put up ‘gates’ on domestic banks’ ability to sell dollars to their clients – through taxes, differential exchange rates, or outright bans – could become more visible,” says Lubin.
His suggestion for warding off this possibility of capital controls is to create a large Special Drawing Rights to increase global liquidity well beyond the US$1 trillion of lending capacity that the IMF currently has.
“Things might change in the coming weeks. But as things stand, the longer the virus stays with us, the more capital mobility across emerging markets might be threatened,” says Lubin.
