An Official Keynesian Reading of Cap Inflows and Emerging Markets

06-18-09 © eldorado3dWhat is the consequence of an influx of capital upon the economy of an emerging-market nation? With the usual ceteris paribus qualification, does the influx increase or decrease productivity?

We can easily put the puzzle into a form more suited for EM alpha hunters. If you know that money is headed into a particular EM nation, what can you infer?  Is it a good bet? Would you want to go long or short the equities of that nation?

Olivier Blanchard and three other scholars affiliated with the International Monetary Fund have tangled with this question in a recent working paper for the National Bureau of Economic Research.   They have provided what we may provisionally read as official neo-Keynesian reaction.

Two Contrary Hypotheses

H1: The inflow increases the value of the host nation’s currency, reduces its net exports, and in consequence shrinks the economy.

H2. The inflow leads to a credit boom, that is, makes life easier for borrowers, and this leads to an increase in output.

The first hypothesis is part of a broader and elegant theory, or rather a range of theories “along Mundell Fleming lines.” The second hypothesis, though, seems on the fact of it easier to reconcile with observable facts about boom-bust cycles in EM nations.  It is certainly easy to reconcile with the perceptions of policy makers in many such nations.

In the 1960s, Robert Mundell and Marcus Fleming set out a model for small open economies with exchange rates fixed by government policy. Their model purported to show how the money market and the goods market can reach equilibrium only by virtue of adjustments in the exchange rate or by funds flow that has the same effect. The first hypothesis above is part of the workings of this model.

When facts run counter to a theory, there is always the option of simply discarding the theory. But if the theory has other attractions, there is another option: re-examining it to see how much of it can be saved, rendered compatible with the troubling facts, with some minimum of re-interpretation.

Blanchard et al. go the latter route.

These authors make a simple distinction, allowing in their post-Keynesian and post-Mundell model for two sorts of assets: bonds and everything else. With regard to the model for bonds, the inflow of funds will have a “contractionary” effect.  Bonds are assets whose rate of return is directly controlled by monetary policy. The non-bond assets are very imperfect substitutes for bonds, so the contractionary effect of an influx there does not have a lot of spillover into the non-bond realm.

Their model also includes a single class of foreign assets, called for convenience “foreign bonds.” This is an imperfect substitute for either of the two sorts of domestic asset.

The gist of the new (or modified old) model is to show how non-bond inflows, “because they decrease the cost of credit for a given policy rate, are more likely than bond flows to lead to an increase rather than a decrease in output.” All this leaves Mundell Fleming undisturbed in regards to the realm of bond assets. More important, and in answer to our own alpha-hunter paraphrase of their initial question: if you, dear hunter, know that there is about to be a net increase in lending from the rest of the world to the non-financial part of an economy, you might ceteris paribus want to take a long position on that country’s equities, betting on the expansion.

Who Are The Authors?

Blanchard has just stepped down as the chief economist of the International Monetary Fund, a post he has held since 2008.  Each of his co-authors is likewise affiliated with the Research Department of the International Monetary Fund.  They are: Jonathan Ostry, Atish Ghosh, and Marcos Chamon.

The article might be understood as a parting shot from Blanchard, one of the most cited economists in the world, according to the Economist Ratings at IDEAS.



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