Stem flow of speculative capital, top economist urges markets

Stanford University economist Ronald McKinnon says emerging markets must impose measures to temper the flow of speculative capital and prevent potential bubbles arising from what he considers to be the US Federal Reserve’s “excessively loose” monetary policy.

McKinnon, who was in town last week for the Asian Development Bank annual meetings, said in an interview with the Inquirer that the US Federal Reserve was “under a very bad management.”

In a presentation before the ADB’s Board of Governors, the economist said the US Fed should abandon its zero interest policy and phase in modestly higher rates in conjunction with the other industrial countries represented by the European Central Bank, Bank of England and Bank of Japan.

The extremely low interest rate regime in these developed markets, McKinnon said, was encouraging carry trade or the borrowing of low-cost money for investment in high-yielding emerging markets. “There is tremendous tendency to borrow in New York to invest in the Philippines or Brazil or China at higher interest rates,” he explained.

This is creating potential bubbles, the economist warned, and likewise creating monetary control problems because emerging markets would not want their currencies to appreciate too sharply.

“So each central bank intervenes to buy dollars and prevent their currencies from appreciating but when they do that, they lose monetary control,” McKinnon said, adding that central banks would then “sterilize” liquidity by raising the reserve requirement or other mopping up tools.

In this regard, McKinnon also favors the imposition by emerging markets of capital controls.

“The inflows can suddenly reverse,” he warned.

US Fed chair Ben Bernanke has said that interest rates were likely to remain low until 2014 but the economist said the monetary chief has the “wrong model in his head.”

“It’s been a disaster for the financial markets,” noting that many US pension funds could not meet their actuarial obligations because of poor asset yields.

He said this was causing “tremendous financial stress.”

Emerging markets like Brazil, the economist said, had already complained with US President Obama about this huge monetary expansion caused by the US Fed’s near-zero interest rates.

Apart from slashing key interest rates, the US Fed has also engaged in a bond buyback scheme to infuse more liquidity when there was no more room to cut nominal rates.

This scheme is more popularly known as “quantitative easing.”

The economist said everyone would benefit if the US Fed and other major central banks would reduce interest rate differentials with emerging markets by raising their interest rates by a “modest” level.