Exit strategies – an international dimension

Lorenzo Bini Smaghi of ECB gives an international dimension to the exit strategies in his speech. Each economy would be weary of exiting first as there is uncertainty and it could damage its economy’s prospects

He says looking at the current economic conditions the ideal international exit strategy would be first Asia, then Latin America and then US and advanced economies.

This ‘optimal’ sequence would mean that Emerging Asia tightens its policies as the economy gets back on track, thus avoiding domestic overheating and financial instability. The exit would be accompanied by an appreciation of Asian currencies, and that in turn would favour a rebalancing of growth towards domestic demand, thereby avoiding a large build-up of foreign exchange reserves and excess domestic liquidity.

It would also entail a progressive reduction of liquidity flows to the US, which were probably useful as the crisis escalated but are becoming less so as financial markets stabilise in the US.

Latin American countries would be the next to exit, as their economies recover gradually, thanks also to exports to Emerging Asia and to stronger domestic demand. In Latin America too, some appreciation of the exchange rates would be expected to accompany the recovery and stem excessive capital inflows.

The US and other advanced countries would exit last, as their economies are proving to be the slowest to recover. This would be the ideal sequence.

However this is not happening

Unfortunately, the reality appears to be quite different. Emerging Asian economies have not yet exited and do not seem to be in the mood to exit first, despite the stronger pace of their recovery, at least compared with that of the US. They continue to maintain strongly accommodative monetary policies and steadily accumulate foreign exchange reserves.

In all Emerging Asia, except Malaysia, foreign reserves are now higher than before the Lehman collapse (see attached table). As a result of these interventions, the strong domestic demand for credit is being met, fuelling potential financial market instability in these countries. Just to give an example, the year-on-year growth rate of domestic credit has reached 32% in China.

Delayed exit in Asia is posing problems for Latam as well as the capital flows are moving to Latam as well leading to appreciation. They are also likely to respond and manage capital flows. Brazil has already responded.

Why is this happening? He points to three possible reasons:

  • Philosophical: When advanced economies want to delay exits why should emerging exit now?
  • Tactical: The emerging economies need to be sure that advanced econs would also exit if their economies recover. As they are not sure now, they are not exiting
  • Prudential: Need to be sure that crisis is over before exiting

Interesting dimensions to the international exit strategy problem. He summarises it as:

Let me conclude. An optimal exit strategy from the extraordinary monetary, fiscal and financial policies implemented by advanced and emerging market economies has several elements. It has to be timed properly, in all countries. This is difficult: not all countries are in the same cyclical position, so some should exit earlier than others. However, those who should exit earlier can do so if they are confident that those who are supposed to exit later will do so in the same timely fashion. Furthermore, they want to be sure that the worst of the crisis is over and that concrete actions are being taken to overhaul the financial system. To make such commitments credible and to build up that confidence, we need a stronger system of international cooperation than the current one, with the major countries undertaking to bear in mind the external implications of their actions. Without a stronger multilateral system we might end up repeating the mistakes of the past, with one difference. The impact on each of us will be greater.

International cooperation…we always look to it but is disappointing. This crisis we have moved a bit forward on the crisis. As the crisis is easing we are again seeing a scramble for world supremacy.

Useful stuff from Smaghi. He usually is quite good.



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