A woman checks food prices outside a supermarket in Beijing on Thursday. Food prices in China surged last year, driving inflation to rise by 5.1 per cent in November. The World Bank fears capital inflows to emerging economies are contributing to the rise in prices.FREDERIC J. BROWN
Let's agree that Europe's debt crisis is the biggest short-term peril facing the world economy. What's the second biggest? Increasingly, the guardians of the world economy appear to think it's the rush of international capital to the bigger emerging market countries.
In its latest global economic outlook, the World Bank cites three major risks to its forecast for not-too-hot-not-too-cold growth of 3.3 per cent this year. The first: Europe. The second: "the possibility that very low interest rates in high-income countries induce a second 'boom-bust' cycle among one or more developing countries." (The third is higher commodity prices, which threaten the recoveries of developing countries, which devote a greater share of their incomes to food and energy.)
Finance Minister Jim Flaherty, who was in Washington on Wednesday to give a speech at the Woodrow Wilson International Center, said he's been talking this week to counterparts from the Group of Seven rich industrial countries about Europe's struggles to convince investors that the political will exists on the continent to prevent a default by Portugal, Spain, Belgium, Italy and any other member of the European Union.
But Mr. Flaherty also expressed concern over the various measures countries ranging from Chile to Thailand are taking to ease the flow of inward capital, which puts upward pressure on their currencies. These "unco-ordinated measures," Mr. Flaherty said, "underscore the need for more co-ordination." Mr. Flaherty's concern is trade tension. As some countries seek to limit the value of their currencies, others will retaliate. Those that take the high road and stick with floating exchange rates end up getting sideswiped. Canada, for example, is absorbing a "disproportionate" share of global investors searching for yield as currency traders push the value of the loonie to par with the U.S. dollar.
The World Bank's outlook provides the economic rationale for why Mr. Flaherty and his colleagues in the Group of 20 must try to get a handle on this issue.
"Capital inflows into some middle-income countries have placed undue and potentially damaging upward pressure on currencies," the report says. "Many of these flows are short-lived, volatile and sometimes speculative in nature. Left unchecked, such flows can lead to abrupt real appreciations and depreciations that are out of line with underlying fundamentals, and can do lasting damage to economies."
The World Bank says global gross domestic product expanded 3.9 per cent in 2010. Almost half the growth came from developing countries. The institution's economists predict that dynamic will continue over the next two years, as high-income countries struggle with bloated deficits and elevated unemployment rates. The economies of richer nations will expand about 2.4 per cent in 2011, compared with more than 6 per cent in developing countries. In 2012, when the World Bank predicts overall growth of 3.6 per cent, developing countries will again expand at a pace of more than 6 per cent, while high-income economies grow only 2.7 per cent. (The World Bank calls its projected slowdown from 2010 a normal transition from a "rapid, bounce-back phase of recovery, toward a slower, more sustainably paced phase.")
In other words, the world economy can't afford for anything to go wrong in countries such as Brazil and Vietnam.
So what is to be done? The International Monetary Fund said last week that it intends to develop guidelines on the use of capital controls. But that will take some time. In the meantime, the World Bank is encouraging emerging markets to have faith in an old formula: flexible exchange rates.
The World Bank notes that capital inflows in 2010 correlated well with economic growth. The economies of the nine countries that attracted the bulk of these flows grew 8.4 per cent, compared with 3.7 per cent in 2009. The threat going forward is inflation.
Economists at the World Bank are sympathetic to the plight of emerging markets, characterizing their measures in 2010 as necessary to counter "disruptive appreciation" of their currencies. But the report argues the long-term harm of aggressively controlling exchange rates is a bigger threat than the impact of a stronger currency on exporters.
"Although the benefits of preventing a too rapid appreciation are real, there are costs associated with resisting appreciation," the report says. "Among countries that were more successful in resisting the upward pressure on their currencies, several have observed a rapid expansion in the money supply, and signs of mounting inflation pressures in both consumer goods and asset markets."
The most aggressive way of controlling appreciation is intervention, which sees countries accumulate foreign-exchange reserves as they buy dollars and other currencies. The World Bank says several countries, including Thailand, China and Malaysia, have accumulated reserves worth more than 40 per cent of GDP. This is money that could be invested in health insurance, schools and roads. Stronger currencies also help control inflation by making imports less expensive.
But there might be another reason to rethink attempts to impede currency appreciation: it doesn't work very well.
"Despite efforts to control inflows and resist appreciation, Brazil, Colombia, Thailand and South Africa were among those countries whose currencies appreciated more than 7 per cent in real-effective terms since January 2010, and by between 20 and 30 per cent since January 2009," the World Bank report says.