Emerging Markets Confront QE2: Capital Controls, Reserve Accumulation, or Both?


Paul Jay: You recently wrote a piece in the Guardian.  The title is “Who Pays the Bill for the Fed’s QE2?  By Depressing US Interest Rates, Quantitative Easing Forces Developing Countries to Defend Their Currencies at Crippling Cost.”  What do you mean by that?

Kevin P. Gallagher: One of the unintended effects of QE2 is that there are going to be massive capital flows from the United States to emerging markets or developing countries.  Why?  Because with the interest rate low, banks and investors can borrow money in the United States and then park it in places where there’s going to be a higher interest rate.  This is called the carry trade. . . .  So you’re pulling money out of the United States at a low interest rate, 2, 3, 4 percent, parking it somewhere like Brazil, 10.53 percent.  That’s an amazing, quick markup.   Can’t get that in the US economy anywhere. . . .  [S]o there have been massive inflows of capital to the developing world.  It has two effects.  One, it raises their currencies, so their exports are more expensive.  Brazil’s currency’s risen by 37 percent since 2008.  Their stuff’s more expensive out there in the world.  So as we are trying to stimulate our economy, they can’t get many markets around the world because their stuff’s too expensive.  That’s one thing.  The other thing . . . is the fact that this is speculative capital that’s going to move in and out of their country and could cause asset bubbles in . . . their economy.  And just as quickly as it comes in, if there’s a change in the interest rate in the United States or a little scare in a country, it can pull right out and destabilize their financial system. . . .  Bernanke said that the US is trying to get its own ship in order and you should try to get your own ship in order.  What they’re going to do to get their own ship in order is put in place capital controls.  These are instruments to try to keep the short-term hot money out of their country.  They’ll also accumulate more T-bills or accumulate more reserves to be able to make sure that their currencies are more stable. . . .

Paul Jay: Give us some specific examples how this is what you say a “crippling cost” for some of the emerging economies.  Give us an example of what that is.

Kevin P. Gallagher: Well, there are two things, right?  One of the things is reserve accumulation.  That’s where the biggest cost is.  So if I need to stabilize my currency, if there’s all this hot money coming into my country, dollars coming into my country, that is going to raise the level of my currency.  So what I need to do is buy those dollars, get them off the street.  And I do that by taking my own currency and purchasing those dollars so there’s a lot of my currency out on the street.  The more of it there is, the cheaper it is — it’ll keep down the currency.  Well, those dollars, by purpose, have a low interest rate, and so the returns for that investment that a country’s going to make are relatively low.  And emerging markets, developing countries are growing faster than the US, so they can be putting the money into their own country.  There have been a number of studies that have shown that the economic costs are significant.  A Harvard economist did a study that showed that the economic costs of purchasing reserves is about 1 percent of your GDP.  So it’s a 1 percent GDP loss for many countries. . . .

Paul Jay: And you deflate your currency.

Kevin P. Gallagher: You deflate your own currency.

Paul Jay: So, in other words, it’s a countermeasure.  So if one of the objectives of QE2 was to raise the value of other currencies in order to induce people to buy more American products, this counteracts that.  So you wind up in a currency war where these economies just wind up at the same net result, except the banks make a ton of money on the way.

Kevin P. Gallagher: Sure.  The Brazilian finance minister has already said we’re in the middle of a currency war and that the QE2 is only going to accentuate this. . . .

Paul Jay: Now, the Chinese currency is pegged to the US dollar.  Does it actually affect the Chinese, this QE2?

Kevin P. Gallagher: No.  They’re pegged, so they purchase more dollars as our currency deflates, which increases the value of their reserves, and their reserves are almost $3 trillion already.  The accumulation of all these reserves is one of the core reasons why we have this financial crisis.  These Asian countries, for the most part China, have been accumulating so many reserves.  This has accentuated what we’re calling the global imbalances.  So in order to save their country or their currency, many developing countries are accentuating some of the root causes of the crisis. . . .

Paul Jay: Let me understand one of the reasons this is happening.  You’ve got massive amounts of capital in very few hands around the world looking for places to go, and there’s not a heck of a lot of productive places to put it, if I understand it correctly, particularly in United States and Europe.  There’s so little consumer demand.  It’s not like you’re going to open up a new shoe factory.  So you run around looking for margins on your money.  Capital’s jumping from one country to another to see if they can get a spread on cheap money — borrow cheap money over here and earn it over there.  So what’s the effect of that?  And what would capital controls do to prevent that or stop that?

Kevin P. Gallagher: Yeah, you’ve got it exactly right, Paul, that interest rates are low and demand is low in the developed world, so global investors say, hey, I can get money cheap out of the developed countries, mainly the United States, Europe, and so forth, and I can park it in places with higher interest rates or that seem to be growing a little faster, to recover from the crisis and make a quick buck, and then maybe pull it back into the United States or put it somewhere else. . . .  It’s causing a high demand for their currencies and for things in their economy, which is making their currencies appreciate, and it’s causing things like asset bubbles, housing bubbles, stock bubbles in different countries as well.

Paul Jay: It’s a little counterintuitive.  For so long, countries were competing to get foreign investment.  Now they’re getting these inflows and they actually want to use capital controls to slow it down.  So what countries have capital controls right now?  And what’s the mechanism?  What does it look like?

Kevin P. Gallagher: There are two different kinds.  There are what we call market-based capital controls and quantity-based capital controls.  Brazil’s an example of a market-based kind.  They have a tax.  It just works just like a tax or a tariff.  So they say, for certain kinds of investment that come in, speculative capital, it has to have a 6 percent tax, and they get taxed 6 percent.  Other countries, like Thailand a few years ago, had something called unremunerated reserve requirements.  Sounds nerdy.  It’s sort of a tax and a quantitative control as well.  They take your money but say 30 percent of the value of this investment has to go into the central bank, denominated in a local currency, for six months.  So if something bad or perceived to be bad is going on in the country, and investors want to pull their money out real quick, at least a certain amount of it is staying in the country, so it isn’t as destabilizing. . . .

Paul Jay: Now, what stops a Brazil from just saying, okay, we don’t want your short-term money, period?  Like, are they buying Brazilian government bonds?  I mean, the government of Brazil can simply stop issuing bonds.

Kevin P. Gallagher: Brazil, each month, they get closer and closer to that.  They started out with a 2 percent tax, and it was a little low.  A lot of investment was still coming in.  They bumped it up to 4 percent, and then they bumped it up to 6 percent. . . .

Paul Jay: For decades US policy, directly through US government and also US control of the IMF, was so against these capital controls.  So what’s the legality of this now?

Kevin P. Gallagher: If you don’t have a trade agreement with the United States, you’re free and easy to use capital controls.  But if you’ve signed a trade agreement with the United States during the first Bush administration, the Clinton administration, or the last Bush administration, capital controls are actually illegal.  Not only are they illegal, but a private investor, say a bond holder or a private firm, JPMorgan, can sue another country if they put in place capital controls.

Paul Jay: But most of the countries we’re talking about must have trade agreements with the United States.  Brazil must have trade agreements.  But they seem to . . . .

Kevin P. Gallagher: Interestingly, Brazil has always refused major trade deals with the United States.  They prefer to deal with us at the World Trade Organization.  We tried to do something called the Free Trade Area of the Americas, and they said no, they didn’t want a trade agreement that looked like the North American Free Trade Agreement or the Chile Free Trade Agreement, two agreements that make capital controls illegal.  They didn’t want those agreements, for that and a number of other reasons.

Paul Jay: So the relative independence of many of the Latin American countries, then, who refused to be part of these free trade agreements has given them more tools, you could say, to resist this currency war?

Kevin P. Gallagher: Absolutely.

Kevin P. Gallagher is Associate Professor of International Relations at Boston University and Senior Researcher at the Global Development and Environment Institute.  The videos above were released by The Real News on 11-12 November 2010.  The text above is an edited partial transcript of the interview.

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