The Impossible Trinity: Inflation Targeting, Exchange Rate Management and Open Capital Accounts in Emerging Economies

Abstract

This article contributes to the debate on macroeconomic management and capital account regulations in developing and emerging countries (DECs). It argues that the recommendation by neoclassical economists and international financial institutions (IFIs) to combine an inflation-targeting regime with exchange rate management, whilst maintaining open capital accounts, is not only impossible but also potentially counterproductive. The article draws on extensive semi-structured interviews with currency traders in Brazil and London to show that this is due to the particular way such a regime shapes central bank interventions in the money and foreign exchange markets and the destabilizing way these interventions interact with financial market expectations. The interview results also demonstrate that the guidelines issued by IFIs actually undermine, rather than aid, DEC central banks' initial attempts to manage excessive exchange rate movements. These results support the long-standing argument by heterodox economists and critical international political economists that DECs need to make the exchange rate an explicit instrument and goal of their macroeconomic policy and complement it with comprehensive capital account regulations to reduce the destabilizing impact of international capital flows. The interview results also give some concrete suggestions on how to achieve this.

Global Liquidity, the Private Sector and Debt Sustainability in Sub‐Saharan Africa

“…The emerging signs of reversal of the current global liquidity cycle reveal potential side‐effects of such a strategy, as global investors start demanding higher spreads, reducing their exposure to ‘frontier’ markets (including sub‐Saharan Africa). This testifies to the extent to which the region has become exposed to new vulnerabilities, as a result of financial integration (Akyüz, ; Kaltenbrunner and Painceira, , ).…”

“…Additionally, global liquidity tends to appreciate developing countries’ currencies, as it draws capital inflows, thus lowering the burden of foreign currency debts. Conversely, developing countries become exposed to the risk of liquidity shrinkages in the future (Akyüz, ; Bonizzi, ; Kaltenbrunner, ; Kaltenbrunner and Painceira, , ). Should global liquidity contract, tougher financing conditions, including higher interest rates and depreciating currencies, could lead countries into debt distress and render debt unsustainable.…”

“…This depends on the actions of both private and public actors (Eickmeier et al., ; Landau, ) and in the last decade has been closely associated with the expansionary monetary policy of major advanced economies (Aizenman et al., ; Chen et al., ; Fischer, ; Rey, ; Shin, , ). Abundant global liquidity in the post‐financial crisis years has enabled sub‐Saharan African countries to borrow easily and refinance their debts, while exposing them to the vulnerabilities of liquidity shrinkages and shifts in the risk appetite of global lenders (Akyüz, ; Bonizzi, ; Fischer, ; Kaltenbrunner, ; Kaltenbrunner and Painceira, , ). The growing importance of private actors may also have major consequences via the complex interplay between private and public debt whose interaction and conceptualization is limited in the DSF, as recognized by the latest DSF review (IMF, ).…”

How Financialization Undermines Democracy

“…The liberalization of domestic financial markets and their closer integration into global financial structures have come at a high cost. For instance, their ability to support investment at home is weakened as interest rates must be kept high to attract foreign capital while government resources are used to accumulate hard‐currency reserves rather than channelling them into other policy priorities (see Kaltenbrunner and Painceira, , for a discussion of financialization in Brazil). Since emerging and developing countries are vital for the health of the world economy, more attention to the rising vulnerabilities and costs generated by financialization in these economies is crucial for understanding what the ‘Shape of Things to Come’, addressed by Tooze in the last chapter, might be.…”

Goodbye (Chinese) Shadow Banking, Hello Market‐based Finance

“…Brazil's Finance Minister coined the term ‘currency war’ in 2010 to describe what he, and other DEC policy makers, thought the unconventional monetary policies of the US Federal Reserve meant for DEC markets (Gabor, ). The Federal Reserve was flooding the developing world with cheap dollars, triggering widespread concerns that the ‘wall of money’ surging from the West would bring back the asset bubbles, currency overvaluation and loss of export competitiveness that afflicted DECs at one point or another throughout the Washington Consensus era, episodes that inevitably culminated in currency and financial crises (Gabor, ; Kaltenbrunner and Painceira, ). The global financial crisis did what the East Asian, Russian, Brazilian and Argentinian crises failed to do, weakening the political clout of what Jagdish Bhagwati () termed the ‘Wall Street–Treasury complex’ that successfully pressured developing countries to open their capital accounts.…”