Re-examining central banks' role

The financial crisis that shook the world economy has prompted a re-thinking of central banks' role. Until the crisis, a consensus had developed that central banks should focus on controlling inflation.

In today's ceremony at Los Pinos in which President Calderon created Mexico's Financial Stability Council, Banco de Mexico Governor Agustin Carstens emphasized another of responsibility of central banks: overseeing the stability of the financial system. With the creation of the Financial Stability Council, Mexico is at the vanguard of implementing G-20 initiatives to forestall the repetition of the kind of US-originated financial crisis that rocked the world economy in 2009.

Risk management for countries

The prevailing orthodoxy used to be that interfering with capital flows was just plain bad. That's changed: as eminent an authority as the International Monetary Fund now writes that capital controls may be appropriate under some circumstances.

Brazil enacted a 2% tax on foreign purchases of stocks and fixed income investments in October of 2009. Last month, South Korea announced new restrictions on trading in currency derivatives and the uses to which loans from foreign banks can be put. June also saw Indonesia announce it is requiring investors to hold SBIs, debt issued by the central bank, for a minimum of one month.

What justifies capital controls? Think of it as countries practicing risk management. Reserves alone aren't always enough to insulate the value of a country's currency from capital flows, either in or out. When the exchange rate floats, capital inflows can provoke an appreciation that feeds asset bubbles and distorts trade flows. If, as was the case in late 2008 and early 2009, there's an abrupt reversal of investors' tolerance for risk and capital flees, a nasty devaluation follows, one that may have nothing to do with the underlying fundamentals of a country's economy. Investors taking advantage of carry trade opportunities (borrowing funds in a low interest rate country which are then invested in another country where interest rates are higher) complicate monetary policy.

As with most things, it's a question of "when" and "how much" with capital controls. A tool that might be used for prudent risk management on the part of one government could be seen by another as an instrument for controlling the exchange rate by another.

How countries can make the most of volatile capital flows while minimizing their risk is a policy issue that's here to stay.

Losing even when you win...

The PRI won nine of the twelve gubernatorial seats up for grabs in Sunday's elections. So, how is that a loss? They were expected to sweep all twelve. Instead, PAN-PRD coalitions eked out victories in Oaxaca, Puebla, and Sinaloa. The coalition triumphs are especially telling in the former two states, amongst Mexico's poorest and noted for their traditional politics.

Even though the PAN-PRD alliances did better than expected, the coalition candidates did not win in the three states the PAN and PRD governed going into the July 4 elections.