Peripheral markets run the vigilante gauntlet

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The Independent Online
The vigilantes in the bond and currency markets have once again enforced their particular brand of justice on several recalcitrant nations in the past few weeks. After a quiet period in the global markets towards the end of last year, the unexpec ted devaluation of the Mexican peso on 20 December unleashed another wave of sudden retrenchment in cross-border investment flows, this time triggering a collapse in the debt and equity markets of Latin America, the Pacific Rim and the peripheral countri es of Europe.

Many of these effects were not driven by economic "fundamentals" as we usually know them. But one factor all the affected countries had in common was that they have been large-scale recipients of capital inflows during the past few years. Initially, these were driven at least partly by a desire to avoid the low returns on cash and bonds that were available in the large developed economies before last year.

This, and the appearance of economic reform in previously unattractive countries, drove risk premiums on peripheral assets - whether Mexican and Italian bonds or Far Eastern and Scandinavian equities - down to very low levels Now that interest rates in all the large developed countries are on rising trends, the benchmark against which returns in the peripheral markets are measured has increased. Furthermore, isolated incidents such as the sudden Mexican devaluation remind investors that the path of economic reform can be extremely rocky, so they require higher relative returns in the peripheral markets to induce them to invest there. Market prices and exchange rates need to fall so that the prospective returns in these areas in the future can increase.

Upward march Once risk premiums have risen in this way, it typically takes quite a while for them to subside, and at present they appear unlikely to shrink until there is some indication of a pause in the upward march of global interest rates. This in turn will require more compelling evidence of a slowdown in activity in the developed economies, most notably in the US, than has so far been apparent.

But looking further into the future, investment in peripheral markets will continue to be attractive for as long as these countries are willing to embrace the combination of free market reforms with fiscal and monetary discipline which has been so prevalent in recent years. As countries as disparate as Britain, Spain, Mexico, Thailand and Hungary have competed to become attractive locations for inward capital flows, the agenda for reform has been set by the prevailing philosophy of the market vigilantes. And to remain attractive to foreign capital, countries have continuously to pass what I shall call the three tests of the vigilantes. These ensure that the value of investment in a given country will not be undermined by domestic inflation, government default, or foreign exchange devaluation.

First, the setting of monetary policy has to be removed from the political process. In some countries, such as Argentina, governments have gone to the extreme of replacing central banks by "currency boards", which stand ready to exchange domestic banknotes for dollars at fixed rates. When a confidence crisis hit the domestic currency after the Mexico devaluation, the Argentines at one point seemed willing to complete the "dollarisation" of their economy if that was necessary to stem the speculative attack.

Complete dollarisation - or in a future European monetary union the replacement of domestic currencies by a mark lookalike - is the ultimate way of persuading the vigilantes that central banks can no longer print domestic banknotes to finance budget deficits. A less convincing alternative, but still pretty persuasive, is to create a central bank that is forbidden from printing money to finance budget deficits, and is entirely independent of the political process in setting interest rates. But these reforms will not convince unless two other factors are also present. The second test of the vigilantes is that budget deficits must themselves be consistent with low and stable ratios of public debt to gross domestic product. Even if bud get deficits cannot be monetised by the central bank, and are entirely financed in the bond markets, there are risks of eventual default if the bond issue becomes too large, and the burden of debt service too onerous Rising risk premiums in countries such as Sweden, Italy and Canada are occurring because the vigilantes are sceptical about the ability of democratic governments in those countries to take the necessary action to bring budget deficits down. With electorates already in revolt against higher taxes in almost every democracy, this would involve a combination of privatisation and cuts in public services much deeper than some governments seem ready to contemplate. (In fact, a sub-test here is that the ratio of public spending to GDP should not be too large, even when this is financed by high taxation. The vigilantes are sufficiently leery to expect future tax revolts even where none exists at present.)

The third vigilante test relates to the exchange rate and the trade account. There must be no significant overvaluation of the currency. This unfortunately often occurs when a new monetary regime is imposed on a country that has previously experienced rapid inflation. In the early days of the new regime, inflation remains high, but the central bank seeks to stabilise the exchange rate. This leads to an overvalued currency that is subsequently hard to correct without a credibility-damaging devaluation. So a failure of the third test can stem directly from passing the first Trade deficit In addition, and related to the exchange rate, there must not be a chronic trade deficit, and certainly not one that is being financed by short-term capital inflows responding to temporarily high interest rates. This is not seen as a sustainable position even if everything else, including the budget deficit, passes the vigilante tests. (It was the failure of this last test that caused the Mexican debacle.) So the vigilantes are on the look-out for independent central banks, sustainable budget deficits with low ratios of public spending to GDP, a fairly valued exchange rate and a trade position that is either close to balance, or which is being financed by long-term investment flows.

Different countries pass these tests to different degrees, but the punishment that can now be imposed by the vigilantes for deviating from their tests is very swift and very intense - so much so that most countries will not be willing to risk the markets' wrath. In fact, one of the key arguments for investing in emerging nations is that they appear to have no realistic alternative - other than autarky and complete withdrawal from the world's financial system - to pressing ahead with reform.

And by the same token, the rewards for good behaviour can be very substantial. One country - not quite an emerging nation, but one that would have been in the "high-risk" club a couple of years ago - is Britain As the Chancellor pointed out, Britain has been hardly touched by the fall-out from the Mexican crisis, and has clearly now differentiated itself from the likes of Spain, Italy and Sweden. The tough budgetary measures of 1993, partial reform of the Bank of England, and good trade figures now allow us to pass most of the vigilante tests, and mean we stand to gain, rather than lose, from a "flight to quality" in the global markets.

These rewards for fiscal and monetary stringency may not be visible enough to impress some of the Chancellor's own supporters, but they are very real none the less.