A steady return to “normalcy” in the US and Europe in growth and employment and financial market conditions, and the accompanying monetary and fiscal tightening could draw funds gradually back to them without a sharp break in capital flows to DEEs. The US economy is now under deflation-like conditions and in order to sustain recovery and accelerate growth, the Fed wants to encourage inflation in both product and asset markets through aggressive monetary easing (Bernanke, 2010). However, so far this has not been happening to a significant degree. Rather, US monetary expansion is adding to the boom in international commodity markets and credit and asset bubbles in major DEEs which are already facing overheating.

 

If continued policy of easy money in the US, strong growth in DEEs, expansion of index-based trading and investment in commodity futures and political unrest in the Middle East and North Africa sustain the boom in commodity markets, the Fed could eventually face inflation, but not of the kind it wants. The boom in capital flows to DEEs could then end in much the same way as the first post-war boom ended in the early 1980s – that is, with an abrupt shift of the US Fed to a contractionary monetary policy even before the economy fully recovers from the subprime crisis. A mitigating factor is that today a wage-price spiral is much less likely to emerge than in the 1970s because of significantly changed conditions in labour markets and reduced bargaining power of labour. Nevertheless, the bond market can still force the Fed to tighten even in the absence of strong wage response to higher oil and non-oil commodity prices in anticipation of rising inflation.

 

Another possible scenario is that the surge in capital flows can be brought to an end by a crisis in a major emerging economy, even without a US exit from expansionary monetary policy. This can happen as a result of a balance-of-payments crisis. An abrupt change in the willingness of international creditors and lenders to maintain exposure to a major emerging economy with an appreciating currency and mounting current account deficits could trigger a reversal of capital flows, leading to contagion across other DEEs, as in the East Asian crisis. It can also happen as a result of a domestic banking and debt crisis brought about by an unsustainable process of credit expansion and debt accumulation, as under the subprime crisis. The likelihood of such a scenario is greater the longer the duration of the boom in capital inflows to DEEs.

 

Developments in China could no doubt have a strong impact on global financial conditions and capital flows to DEEs. If Chinese growth continues with full force, commodity prices are likely to remain strong, creating destabilizing impulses both for itself and the US. It could thus precipitate monetary tightening in the US. If, on the other hand, China cuts its growth considerably to counter such impulses, it can bring about a rapid turnaround in commodity prices and capital flows to DEEs, notably to commodity-rich countries.

 

A scenario along these lines is recently presented by Oliver Wyman (2011).   According to this, the continued boom in commodity prices could eventually cause rampant inflation in China. This could lead to a real appreciation of its currency, as long advocated by the US, but would also slow its growth by triggering tighter monetary policy.  A sizeable slowdown of growth in China would reduce demand for commodities, both for real use and as hedges against inflation. This, together with the global oversupply built during the boom, would bring down commodity prices, and the downturn would be aggravated by an exit of large sums of money from commodity futures. This would make investment in commodity-rich countries unviable and loans non-performing.   All these could lead to a generalized increase in risk aversion, flight to safety and a reversal of capital flows to DEEs.  

 

As noted the government in China has already taken measures along these lines to control inflation. However, it is not clear if these would lead to the kind of downturn in Chinese growth, global commodity markets and capital flows envisaged in the scenario above. It is quite unlikely that the government would be willing to cool the economy considerably, given its commitment to strong growth.

 

All in all, the most likely outcome would be the coincidence of the end of the current boom in capital flows and a reversal of the upswing in commodity prices even though it is difficult to predict the dynamic that would bring it about. In terms of vulnerability and exposure to such an eventuality, it is possible to distinguish among three types of DEEs.   The most vulnerable are those which have been enjoying the twin benefits of global liquidity expansion – that is, the boom in commodity prices and capital flows. Most of these are located in Latin America and Africa, and some of them, e.g., Brazil and South Africa, have been running growing current account deficits despite the commodity bonanza. These countries could thus be hit twice, as in the early 1980s, by falling capital flows and commodity prices. The South East Asian countries which have also been enjoying the boom in commodity prices are less vulnerable because many of them have been running current account surpluses, preventing sharp appreciations and accumulating large stocks of reserves. 

 

Exporters of manufactures and services which have been experiencing relatively rapid appreciations and running current account deficits, such as India and Turkey, can benefit from a downturn in commodity prices, notably in oil, as they did during the Lehman collapse, but they could still be hit by a reversal of capital flows. They could encounter sharp currency and asset declines and insolvency in private firms due to their exposure to interest rate and exchange rate risks.