Misguided policies for dealing with high inflation and a flood of capital into emerging markets could lead to financial instability and weak economic growth, the Bank of Canada said on Saturday. "The stakes are very high," said Bank of Canada Governor Mark Carney in a speech at the annual meeting of the Inter-American Development Bank in Calgary.
"The current dynamics of commodity prices and capital flows create major risks to financial stability and sustainable growth across our region," he said. Carney said some countries were postponing interest rate hikes, needed to arrest inflation, for fear of further boosting currencies that have already been pushed higher due to heavy capital inflows.
As the world recovers from recession, nations have clashed over foreign exchange policy as many countries adjust to ultra-low US interest rates and China's reluctance to let the yuan appreciate more freely. Investors seeking high yields have sunk their money into Latin America, exacerbating these tensions. Referring to what Brazil's finance minister dubbed the "currency wars," Carney said that when large economies keep their currencies from appreciating, others feel pressured to follow suit. This leads to a chain reaction of other distortional policies.
"The collective impact of this behaviour risks inflation and asset bubbles in emerging economies and, over time, subpar global growth," he said. Carney sees the current high commodity prices persisting for much longer than in past boom cycles because of the rapid urbanisation and mushrooming middle classes in emerging economies such as China and India.
"Even though history teaches that all booms are finite, this one could go on for some time," he said. The other thing that is different about this commodity boom - and which could lead to dangerous global imbalances - is that the strong demand from emerging markets is combined with tepid growth in core advanced economies such as the United States.
This shift to a "multipolar economy" is permanent and should not be underestimated, Carney said. "Some countries are postponing monetary tightening in the hope that old relationships reassert." Others have introduced measures to curb capital inflows. "All appear to be underestimating the scale of what is happening. Therein lies the risk of another crisis," he said.
Carney said Latin America is the region most affected by these pressures. However, he too has grappled with a sharp currency appreciation in Canada that has hampered the country's recovery and allowed him to keep benchmark interest rates on hold since last September. Foreign investors also bought a record amount in Canadian securities last year. In terms of measures that can be taken in the short term to contain these pressures, Carney proposed a renewed commitment among G7 countries for floating exchange rates and a global code of conduct on capital flows.