Facing financial crisis and capital flight, troubled emerging economies may well follow Iceland in cutting rates and raising capital controls – leaving panic-stricken foreign investors struggling to get out. That would represent a reversal of the economic consensus of the 1990s, when the International Monetary Fund pushed crisis-hit countries into hiking rates sharply, slashing local demand through raising borrowing costs but attracting foreign investors. The theory then was that foreign cash inflows would help refloat the economy after a period of local pain. This time, however, some suspect it could be almost the other way around. Many investors have already sprinted for the doors, with record outflows from developing markets that have seen emerging stock markets lose half their value worldwide since May. Much of that has been simple risk aversion – but part is fear of being trapped. With its highly indebted banking sector collapsing and its currency effectively untradeable internationally, Iceland slashed interest rates by 350 basis points on Wednesday to 12 percent. Remaining foreign currency in the country is tightly controlled, with firms limited to purchases of essentials such as food, fuel and medicine. A daily foreign exchange auction to set value to the crown has so far only been attended by local banks – now almost all under government control. “It is happening – this is the new reality,” said Michael Ganske, Commerzbank head of emerging markets research. “When you have real panic in markets, capital controls can be necessary but it is also bad for investors because you always want the ability to adjust your positions.” With Iceland's August inflation already 15 percent and expected to soar after the currency collapsed, its interest rates are now negative in real terms. That, policymakers hope, should help soften an already inevitable hard landing. “Capital controls are the only way a country can cut rates safely when capital is leaving the country,” Citi said in a note. “There could be important implications here for policymaking in other countries.” Analysts are already worrying about a string of other countries from the Baltic States to South Africa with large current-account deficits or debt refinancing needs. In the short term, Ukraine and Hungary are seen first in the firing line. Ratings agency Standard & Poor's this week warned they were considering downgrading both on worries over their domestic banking sectors. Both countries are already talking to the IMF, although in the case of Hungary the European Central Bank would likely take the lead. That leaves investors wondering if even the IMF itself would still stick to its 1990s strategies, or also embrace rate cuts and capital controls. “What Iceland has done could well be the pattern that other countries might follow,” said Royal Bank of Canada emerging market strategist Nigel Rendell. “The IMF itself might also go down the same route. There does seem to be a feeling they were too harsh with countries such as Korea in 1998.” Even more crucially, some analysts say more recent analysis of the Asian crisis suggests economies such as Malaysia, which went down the capital controls route, did better than those which slavishly followed the IMF advice at the time. Citi says fears of capital controls may also be a factor in ballooning emerging debt insurance costs in the credit default swaps market, with Ukrainian CDS out at 1900 basis points against 340 in June. That means it would cost $1.9 million a year to cover $10 million of five-year debt – practically pricing in default. But other analysts say rising worries over counterparty risk and that CDS insurers might not pay out are also a factor. Some other countries have already imposed relatively mild restrictions on capital flight. Russia has repeatedly closed its stock markets for short periods after drastic volatility in both directions. Taiwan this week halved the daily limit it would allow stock prices to fall to 3.5 percent, having watched other Asian exchanges drop an average of more than 7 percent the previous week. As part of a wider bank stabilisation package this week, Ukraine limited the margin with which exchange bureaux could buy and sell foreign currencies. It said it was aiming to “neutralise the effects from the global financial crisis”. If slashing rates and raising capital controls works in stemming the crisis, investors including foreign asset managers will ultimately benefit and cheer them. But at worst, some analysts fear an increasing new cycle of protectionism that will cut off economies from each other and potentially raise political tensions. – Reuters __
