Don’t Try This at Home: Modern Monetary Theory in Emerging Economies

Modern Monetary Theory (MMT)

Modern Monetary Theory (MMT) has attracted attention recently in the United States in part because it has become associated with certain Democratic Presidential hopefuls, but also because it has been noticed by Wall Street Bankers.[1] Proponents of MMT argue that governments should use fiscal policy to maintain full employment even if doing so leads to budget deficits and an increase in government debt. There is no need to worry that the government will not be able to service the debt as long as it is denominated in the domestic currency. The central bank as an agent of the government can always create enough money to make interest and principal payments. Furthermore, as long as fiscal policy is able to control inflation, the money creation is not inflationary.[2]

This post is not about MMT as such, but rather a warning not to try it in emerging markets. There are many reasons for this, all of them related to the fact that the value of emerging market sovereign debt is at the mercy of developments in international capital markets.

Original Sin

The first problem is that much of emerging market sovereign debt is denominated in US dollars, i.e. not in the domestic currency. This means that the central bank cannot issue domestic currency to pay interest and principal. These payments need to be made in US dollars that need to be accumulated in advance or earned. Accumulated dollar reserves are by definition finite so they cannot be counted on to service external debt on a permanent basis. Earning US dollars means generating current account surpluses, which requires either a government budget surplus or an excess of savings over investment in the private sector. In either case, the ability of fiscal policy to maintain full employment is severely constrained.

Capital Inflow Surges and Sudden Stops

It is well known that capital flows to emerging countries tend to be highly volatile characterized by surges of inflows when international investors seek to benefit from high yields in emerging markets only to be followed by sudden reversals in flows when investors cut their exposures to these markets. In the early stage of a debt-financed fiscal expansion, when investors are have not yet begun to question its longer-term viability, international investors will be happy to provide financing as the interest rate on the debt will be high and the currency will be appreciating. There will be a surge of capital inflows and the external debt of the country will be expanding rapidly. At some point, however, sentiment will change and the foreign capital will come to a sudden stop. The currency will crash, and the US dollar denominated debt service burden will be correspondingly increased. With no further capital inflows, the current account deficit can no longer be financed and a painful adjustment is forced on the economy.

Debt Denominated in Domestic Currency

But what about emerging market economies that can issue sovereign debt denominated in their own currency? Will they not be operating in the MMT world? No. If the central bank uses the printing press to service domestic-currency denominated debt, the consequences are also likely to be dire. In an open economy with a flexible exchange rate, an expansionary monetary policy will lead to a currency depreciation and imported inflation. Fiscal policy will not be able to contain this source of inflation, so the entire premise of the MMT is negated. Furthermore, the ability to issue debt in domestic currency may be squandered away by seeking to exploit it.