The Global Financial Crisis (GFC) ushered in an era of macroeconomic and prudential innovation. While advanced economies tamed excessive risk-taking in financial markets, emerging economies focused more on the financial instability and production distortions caused by large capital inflows. Few emerging economies showed unambiguous gains from these efforts and many grew above their potential rates, resulting in higher inflation and eventually recessions, real currency appreciation and lower export growth. The 2013 ‘taper tantrum’ and Covid-19 pandemic further entrenched macroeconomic expansion, adding excess demand to cost-push pressures, even as productivity weakened. A decade later, many economies are saddled with stagflation, high fiscal deficits and high sovereign debt levels. Financial fragilities and price bubbles appear persistent. What went wrong?

Few of the microeconomic interventions worked as intended. Efforts to cheapen currencies, as in Brazil, temporarily dampened price bubbles but prompted even more inflows. Deflated house prices in many economies, such as the UK, Sweden or the US, returned to bubble levels after the pandemic. Permanent solutions to bubbling asset prices, like expanding their supply (housing in particular) were either insufficient or just not pursued. Instead, shortages increased, even as liquidity-expanding fiscal and monetary policies remained in place. The basic challenge was that many post-GFC policies featured contradictions that went unrelieved by microprudential efforts and/or were exacerbated by fears of insufficient liquidity. Over time, and through the pandemic period, as markets failed to support asset prices, even more liquidity was provided through sustained low interest rates and new rounds of quantitative easing (G3 central bank balance sheets expanded by 27 percentage points of GDP during the Covid-19 crisis alone). Eventually, that process contributed to inflation, and with it rising interest rates and even more financial volatility.

For emerging markets, the post-GFC period exhibited primarily more risk aversion, less capital flows, weak growth and higher inflation. Offsetting factors, like the positive productivity shocks of globalisation have waned, while the excess supply of global liquidity has been routed to safer assets in advanced economies. The macroeconomic policy variables in control of emerging markets have been even more focused on domestic demand as a source of growth and consequently less sustainable. Average debt levels in Africa, Southeast Asia and Latin America have increased by nearly 20 percentage points of GDP between 2017 and 2023.

Emerging economies need to rebuild fiscal and monetary policy credibility, while getting to higher growth rates that will bolster the space for future policy flexibility. Neither is guaranteed. Reversing the prevailing attitude to capital flows, however, would be a critical signal of intent to achieving outcomes. The older, Asian Crisis-era policy mix looks more attractive in this context, recognising that exchange rates are important channels of macroeconomic adjustment and eschewing the interventions that impede them. Reviews of inflation targeting show the framework outperforming exchange rate pegs in reducing exchange rate volatility, and finding few net benefits of intervention except where countries have large foreign exchange (FX)-denominated debt and shallow financial markets¹. South Africa’s FX interventions were ineffective, and at their height in the 1990s, the rand still depreciated by about 45%. Instead, a good inflation targeting framework and sustainable fiscal policy remove most, but not all, of the challenges associated with currency movements.

When persistent bouts of currency appreciation occur, a credible and asymmetric exchange rate policy ‘leans against the wind’. But such a policy needs to read global economic conditions well and provide signals to build reserves. In the pandemic period, for example, capital inflows and strong terms of trade could have helped build reserve levels, implicitly increasing saving and de-risking the credit profile of the economy as a whole. The policy lever to help achieve better long-run outcomes, however, need not be as direct. The post-2001 increase in South Africa’s foreign assets which, as a ratio of GDP, has increased from 20% in the mid-1990s to about 145% today, is primarily held in the private sector and has proven to be a crucial counter-cyclical offset during the period of capital inflows and macroeconomic expansion. When capital flowed out during both the GFC and the pandemic, private sector inflows increased sustainability of counter-cyclical public spending.

South Africa lets private actors optimise foreign asset holdings within sensible limits, recognising the information asymmetries that exist in foreign markets, while keeping most domestic saving in local currency. Publicly-held foreign currency reserves play an important role in complementing private assets and improve the overall credit profile of the economy. The floating currency also discourages foreign borrowing, one of the banes of the pre-inflation targeting era. This supports local markets while limiting the risk that local financial institutions need to sell assets to pay down foreign currency liabilities.

The capital flows environment is changing fast. The period of capital’s super-abundance has likely ended and competition for capital is intensifying, increasing its propensity to flight, and raising the cost of consumption-led growth models dependent on cheap capital inflows. In the new world we see today, it is crucial that emerging markets prioritise macroeconomic sustainability, lower inflation and stronger productivity growth or risk a long-term capital drought, with less technology, knowledge imports and growth.

¹ See International Monetary Fund (2006). “Inflation Targeting and the IMF”. IMF Policy Paper.