Q1. Do you think a country the size of Iceland or New Zealand is more or less sensitive to the potential impacts of global capital movements?
Smaller countries – as measured by population and economic output – are clearly more sensitive to global capital movements. The sensitivity of a country like Iceland is amplified because of relative size. Capital commitments that are regarded as relatively small by investment banks, global corporations, or money managers in bigger markets like New York and London, can end up literally drowning a smaller open market in a very short time. Countries like Iceland and New Zealand (GDP as 0.1% of U.S. GDP) are actually hyper-sensitive to such threat. As the global financial markets become more integrated and developed, capital flow in and out of a country can fluctuate hugely in a short time. While these changes are relatively small in bigger countries compared to their GDP, and short-term fluctuations can be covered by their reserves, they account for a much significant part in smaller countries GDP, distort BOP and are unable to be bailed out by these governments’ reserves.
Moreover, the global markets see them as comparatively stable and low-risk country markets, making them even more attractive as potential recipients of short-term capital investments. Thus, as the size of short-term capital flows increase, so do its impacts on the country economy.
Q2. Many countries have used interest rate increases to protect their currencies for many years. What are the pros and cons of using this strategy?
Direct intervention in currency markets, in which the central bank of a country buys or sells its own currency to pursue economic objectives, has been largely replaced in many markets by monetary policy and its resulting impact on interest rates.
A country, often small, may choose to protect its currency value by raising interest rates to provide higher returns to global investors. This attracts capital inflows into the country...