Monday, October 27, 2014

Beware of Cross-Border Capital Flows!

I very much enjoy reading John Mauldin's weekly Thoughts from the Frontline. The latest piece is titled A scary story for emerging markets. Mauldin predicts a rather gloomy future for the emerging markets because he fears a soon-to-happen turn-around of the massive capital flows which had gone into these markets since 2008. The possible outcome for emering markets he describes as something which could rival Greece's economic disaster over the last 5 years.

I comment on this article here because, in my opinion, it has a direct bearing on what happened in Greece (and in the Eurozone overall) since the arrival of the Euro. Of all the many reasons which are cited as causes for Greece's problems, if I had to pick one as the most important one, I would pick cross-border capital flows.

No Greek government can misspend foreign capital if there is no foreign capital in the first place. The same goes for the Spanish banking sector and construction industry. Cross-border capital flows can cause a boom as well as a bust. When cross-border capital flows are distorted by a fixed exchange rate (or a common currency) and, additionally, by a misperception of risk resulting from the implied support of a common currency zone, then all hell can brake loose. To me, the story of Greece and the story of the EZ-periphery is a story of cross-border capital flows!

Let me cite this key paragraph from Mauldin's newsletter: 

"Broad-based, debt-fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually, disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse. Economists call that dynamic – an inflow-induced boom followed by an outflow-induced currency crisis – a “balance of payments cycle,” and it tends to occur in three distinct phases. 

In the first phase an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency. 

In the second phase, the allure of continuing high returns morphs into a growth story and attracts ever-stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both, so that ever more inefficient economic growth depends increasingly on foreign capital inflows. Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitate capital flight. 

In the third and final phase, capital flight drives a self-reinforcing cycle of falling asset prices, deteriorating fundamentals, and currency depreciation… which in turn invites more even more capital flight. If this stage of the balance of payments cycle is allowed to play out naturally, the currency can fall well below the level required for the economy to regain competitiveness, sparking runaway inflation and wrecking the economy as asset prices crash".

I am not sure that Greece ever had  a first phase but it certainly had a second phase and it is still living through the third phase, intensified by the fact that Greece could not play out a natural balance of payments cycle with declining exchange rates.

I have argued early on that even the economically most solid country can get into trouble through cross-border capital flows if it has a freely convertible currency and free movement of capital. If foreigners dump irresponsibly high volumes of capital on the economy and if they withdraw that capital at a point where the economy has become used to having it (perhaps even addicted to it), a foreign payments crisis is around the corner.


  1. Klaus, you are pulling my leg, you know Greece did not have a first phase, they went directly into full consumption mode. That is a nasty habit, very hard to kick. I have a friend who says "I'm still an alcoholic, I just don't drink anymore".

    1. The cited theory suggests that during the first phase, 'foreign capital generally flows toward productive uses and reaps attractive returns'. If only part of Greece's foreign capital had flowed into productive uses, things would be different today. Of course it went into consumption and the domestic productive capacity was, if anything, reduced.


    Klaus about this?

    1. I am not sure that the gold holdings of a Central Bank have very much to do with cross-border capital flows.

  3. No, not of course, as a policy for a central bank i asked.

    1. As a policy for a Central Bank, I think it is dangerous because it limits the room for maneuver or a Central Bank. If you read President Jordan's statement, you will understand why.