The current situation of the transfer of capital between the different financial markets is a suitable case study for students in economics. To understand what is happening, it is necessary that I recall on the role of interest rates in capital transfers.
Mundel and Fleming are two economists who have developed this theory. According to them “speculators” are looking for investments with high yields. When interest rates on the domestic markets are above the average of international rates, foreign investors are motivated to invest in the domestic market. It’s normal they want to take advantage of the high return. On the domestic market however, investors facing high interest rates, national do not have the incentive to invest because the cost of borrowing becomes expensive. On the other side people with solid savings rejoice for with high interest, their savings rates grow.
Application: the European Central Bank decided to maintain as long as possible lower interest rates. European investors welcomed this decision which will reinvigorate investment. In Germany, however people, with strong savings do not see this policy with the good eyes, because low interest rates diminish the value of their savings. It is the same thing in the US where the FED has decided to inject into the U.S. economy of money! According to the theory, this practice should lower interest rates and therefore lead to the same results as Europe. American savers are losers while U.S. investors are the winners.
Now let’s look at the other side of the equation with the eyes of speculators!
When domestic interest rates are low, they prefer to transfer financial assets into markets that have high interest rates in order to take advantage of the increase in these rates!
Application: During the 1991 recession, the US in order to create economic growth, lowered interest rates to give a “boost” to overall demand (investment and consumption). Because of this monetary policy, investors (speculators) took their money from the financial market to Latin America where interest rates were not as high but much more attractive for long term profit in fall of a strong economic growth. Between 1991 and 1992 Latin America has experienced a 42.5% increase influx of foreign capital.
What is happening today is not something new!
Economics is a science which repeats itself without anyone to notice it.Early 2009, the economic and financial crisis is in full swing! The FED reduced interest rates in order to bounce the aggregate demand; the Europeans are as much as to zero. Consequences: investors looking for high return on their investments deserted the American and European markets. This time, the direction is not America a group of emerging countries known as the BRICS ‘Brazil-Russia-India-China-South Africa ‘. The honeymoon lasted nearly five years. During this period, trillions of dollars and Euros will rain on the economies of these countries and other frontiers markets. To avoid the excessive entry of currency to be source of inflation, central banks in these countries have even for a time adopted a tight monetary policy through taxation of international capital movement.
This situation is now changing since Europe has managed to save its currency! Greece and the “others” are still members of the euro. In the land of our cousin Obama, economic growth is on his way. The index of industrial production is rising since the beginning of this year. Suddenly the FED does not see any reason to maintain low interest rates, which has been the case since 2008.
May 2013, Bernake announced his intention to stop injecting fresh money into the U.S. economy. It means indirectly that the interest rates on U.S. markets are going soon to increase! Good I mark a break! If you have followed me, then can you tell me where speculators will rush? Not in Latin America please! Earlier as I said it, investor will rush to markets with high “short term” interest rate. This means in the US economy or at worst in the EU land. Now I hope you understand what motivates speculators!
Since the Bernake announcement, emerging countries have experienced an extensive capital outflow. A US Think-than recorded a consecutive fifteen months of capital outflow from emerging countries.Brazilian President Russeff even called unjust, what is happening! The mere announcement and not even the implementation of this decision is enough to disrupt the financial markets of the BRICS.
How should the emerging countries react?
Should they establish restrictions on the capital movement? In June of this year, Brazil has removed its 6% tax on capital transfer and still not managed to stop the bleeding! Should emerging countries raise interest rates to attract again investors? This is dangerous if the rise in interest rates has nothing to do with the fundamentals of the economy!
I think the decision of the Fed should not create a wind of panic on the financial markets of emerging markets countries. The Fed may decide at any time to stop the expansionary monetary policy, investors will not rush everything back in U.S. markets! They will wait and have a clear vision of the U.S. economy (the consolidation of public debt, a still high unemployment).The emerging countries should continue to put their public finances in order in order by reducing their large budget deficits. this applies to South-Africa, Brazil, Turkey and Indonesia.
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