Emerging markets (EM) have generally been seeking to prevent (too rapid an) an exchange rate appreciation since the return of global risk appetite following the April 2009 G20 meeting. Judging by the magnitude of exchange rate changes and FX reserve accumulation, the EM-7 have been experiencing quite different levels of appreciation pressure over the past 24 months. It is noteworthy that five of the EM-7 have weaker nominal effective exchange rates today than before the crisis. Only Brazil and China have stronger or largely unchanged nominal effective exchange rates compared to August 2008. Incidentally, these two countries have also seen a sizeable increase in FX reserves.
Brazil expressed great concern about the monetary and capital flows implications of QE, not least because it faces greater difficulty in dealing with “excess” global liquidity on account of an open capital account and high on-shore interest rates. China, being less concerned about capital inflows than Brazil due extensive capital controls, expressed greater concern about US fiscal deficits given its massive holdings of US government debt.
Policymakers can respond to “excess” inflows in several ways, all of which incur costs – though these costs have to be weighed against the perceived benefits of stemming/slowing currency appreciation. (1) They can allow the exchange rate to appreciate. While this may diminish the attractiveness of local assets in the eyes of foreign investors, it is likely to lead to an “overshooting” of the exchange rate, slowing economic growth and a deteriorating current account position. (2) They can absorb capital inflows into official reserves. If FX intervention is left unsterilised, this will raise domestic inflation. If fully sterilised, this may or may not push up domestic interest rates, but it will typically add to the quasi-fiscal deficit. (3) They can try to limit capital inflows through capital controls and macro-prudential measures. Even if implemented successfully, this may have deleterious effects (e.g. lower secondary market liquidity and higher yields in case foreign fixed-income investors are targeted). (4) They can lower interest rates to reduce the on-shore/off-shore yield differential. Rising inflationary pressure means that this is not an option for EM at the moment. (5) They can tighten fiscal policy. While helpful at the margin, this is unlikely to eliminate “excess” capital inflows altogether.
All responses dealing with capital-inflow-driven currency appreciation caused by low G3 interest rates and exacerbated by QE carry costs for the EM. While US policy actions have a considerable impact on EM, the reverse does not apply. None of the measures taken by the EM will have a material economic or financial impact on the US economy, let alone on the Fed’s decision to pursue QE or the US government’s decision to run large fiscal deficits. Several factors explain this asymmetry. The dollar exchange rate and, even more so, any bilateral exchange rate is far less important to the US than for its EM trading partners. It is precisely for this reason that the threat by EM to sell US assets in an attempt to influence US economic policy is not credible. Capital controls in other countries do not impose any tangible economic or financial costs on the US – other than perhaps opportunity costs for individual US investors. Protectionist measures targeting US exports are not very credible, for assuming the US responds in kind, these more trade-dependent economies would incur relatively greater economic costs than the US. Not only would the economic and financial, let alone political costs of such measures be far greater for these countries than for the US, the costs would also be greater than the benefits thus derived.
Put differently, the US pursues an economic policy – namely a lax fiscal policy and quantitative easing – it deems to be in its interest and however the EM respond to it is of little consequence to the US. This is a prime example of continued US “structural power”. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate – in this instance, the international monetary system. This differs from “relational power”, or the ability of one state to influence another state's behaviour directly in pursuit of specific outcomes. This describes the situation quite accurately, for Washington is not seeking to influence other countries’ policies. It is simply pursuing policies it deems to be in its interest. Meanwhile, the EM have no way of influencing US macro-policy and are therefore left to deal with the QE-driven capital inflows and the implications of rising US government debt.
In short, the US retains maximum policy flexibility, while its choices have a very tangible impact on, and create significant constraints for EM economies. As long as other economies depend more on the US market for their exports than vice versa, they will not only be highly constrained in terms of policy options. They will also wield little in the way of influence that could induce the US to modify its policy. True, the US has thus far failed to get other countries, notably China, to appreciate their currencies. Whether one attributes this to a lack of US relational power vis-à-vis China or simply a reluctance on the part of Washington to wield its power, the fact of US structural monetary power remains the defining characteristic of today’s global monetary and financial system.