Democracy Lab

The One Place Where Washington Can Make a Difference

Burma's democratic transition is running off the rails. Obama and Kerry can help to bring it back on track.

Lately, Washington doesn't have a great track record when it comes to intervening in the affairs of other countries. Obama's minimalist engagement in Syria and Ukraine appears ineffectual. With the gradual return of the Taliban in Afghanistan and Iraq's looming descent into sectarian chaos, America's two grand projects of the last decade loom as failures. Not far away, Israel's offensive in Gaza hints at the unraveling of yet another U.S.-backed peace plan.

Yet there is one part of the world where the United States has a chance to shape events for the better: The tentative democratic opening in Burma is in trouble. And for once Washington is uniquely positioned to bring its diplomatic weight to bear for the better.

Both U.S. Secretary of State John Kerry and President Barack Obama are scheduled to visit the country -- Kerry this week, Obama in November. (In the photo above, Burmese monks hold a sign to welcome President Obama during his first visit in 2012.)

The visits come at a crucial moment. Key reform processes have stalled -- particularly whenever they seem to threaten the military's control of power. Unless the Burmese government can pass constitutional amendments and broker agreements that lock armed resistance groups into a non-violent political process, the structural problems that gave rise to uprisings in 1988 and 2007 and the continuing civil war will persist. The former regime will maintain control under the guise of democratic reform, and the international community will have played most of its cards without gaining much real change in return.

Starting in 2012, the government of President Thein Sein, a former general, has lifted press censorship, granted freedom of assembly, and signed initial ceasefire agreements with more than a dozen ethnic armed groups involved the country's civil war. Hundreds of political prisoners have been freed -- most notably Aung San Suu Kyi, Nobel laureate and champion of democracy, who was released from house arrest and elected to parliament. A lively parliament has embarked on an ambitious program of legislative reform.

The United States can fairly claim some reward. Burma's desire to pursue democratic and economic opening was influenced in no small part by the old guard's recognition that its enforced international isolation had engendered economic stagnation and subservience to China. The U.S. stood ready to gain a foothold at the Western flank of its widely heralded Asian pivot. Washington responded by suspending many of the sanctions it had implemented against the military regime, re-establishing diplomatic ties, and making generous developmental assistance pledges.

In retrospect, the achievements of 2012 were all relatively soft targets. They generated good headlines, but actually did little to challenge the fundamental interests of those in power. When the reforms have actually threatened the position of the elite, the government has instinctively reverted to its old ways, renewing the policy of throwing dissidents in jail and clamping down on critical media outlets.

The promises made in the initial ceasefires with ethnic armed groups have largely gone unfulfilled, while in the country's north, the army has continued a series of abuse-ridden offensives designed to secure its strategic interests in resource-rich areas bordering China. In Rakhine State and elsewhere, unwillingness to protect the rights and lives of vulnerable minorities has been an ugly feature of the transition.

The heady optimism of 2012 seems distant now. Since then, those who truly wield power have shown little willingness to allow the fundamental changes in the structure and exercise of power desired by Burma's democratic and ethnic opposition. Without these amendments, the reform process is at best stunted, and at worst a ploy to fool a naïve international audience.

A reinvigorated constitutional reform process is crucial to getting the reform process back on track. The 2008 constitution ensures military control of the executive and legislative branches of government, bars Aung San Suu Kyi from running for president, and fails to recognize the rights-based and power-sharing aspirations at the heart of Burma's civil war. Addressing these deficits is absolutely essential for the transition, but looks unlikely under the current parliamentary committee review process, which is dominated by military representatives.

A successful transition would also require a resolution to the country's continuing civil war. The state and Burma's non-state ethnic armed groups are currently negotiating a political agreement -- the nationwide ceasefire -- which seeks in tandem to formally end all hostilities while formalizing a longer term process to resolve fundamental power, resource, and rights-based disagreements. To establish a sustainable peace, Burma's old guard must recognize, at least in principle, the possibility of devolving power and resources to non-state actors within a new, possibly federal state structure.

During their upcoming visits to Burma, Kerry and Obama should focus on achieving these benchmarks of progress on constitutional reform and the peace process. There are reasons to believe it has the leverage.

The United States has withheld more of its cards than most of Burma's development partners. Unlike the European Union, the United Kingdom, and others, the United States has refused to partner with Burma's government, putting it in a better position to exert pressure on the government. Unlike other development partners, the United States is not risking any of its existing programs or investments by being critical, and can still use the possibility of closer ties to incentivize "good behavior." It also maintains a relatively strict sanctions regime, which if effectively targeted or re-imposed can still impact the interests of key figures blocking the transition.

At the same time, Washington has opened up avenues of engagement with the Burmese military, giving it closer access to the conservative power structure. The United States could, for example, offer opportunities for non-combat training in U.S. military staff colleges in exchange for the government's commitment to withdraw from contested areas of Kachin state, where the civil war has continued even as other regions have concluded ceasefire agreements.

Engaging rather than isolating Burma's conservative leaders is the best way to change the deeply held belief that devolving power threatens the security and integrity of the state. The people cannot afford to wait another 60 years for such thoughts to dawn independently.

Kerry and Obama's visits to Burma in August and November will come at an auspicious time. By promoting changes to the constitution before the elections, the United States could help Burma foster a truly competitive democratic environment for the first time in half a century. Furthermore, if the United States can persuade the military to cease offensive action and agree to a national dialogue framework, it can help to ensure that power-sharing reforms survive beyond the next electoral cycle. An end to the civil war is possible.

Perhaps most importantly, Kerry and Obama's public assessments of Burma's transition will provide highly visible international and domestic barometers of the country's progress. Rightful condemnations will make other donors' myopia to the derailing of the transition less tenable. Unlike some other countries, the United States is not yet so economically invested in Burma's opening that it can rationalize turning a blind eye. Taking a firm stance at this pivotal moment will deny the regime the international legitimacy it still craves -- and give Burma's people a reason to hope that the world has not been duped, and that real change is still possible.

Paula Bronstein/Getty Images


Your Dollar, Our Problem

Why emerging markets are going to hate Janet Yellen.

Emerging-market and developing countries resented U.S. Federal Reserve Chair Ben Bernanke during his spell in office. In 2012, Brazilian President Dilma Rousseff scolded Bernanke and the Fed's loose monetary policy for creating a "tsunami" of financial flows to emerging markets that was appreciating currencies, causing asset bubbles, and exporting financial instability to the developing world.

It may just turn out that they dislike Janet Yellen even more. Although it was Bernanke who started tapering the Fed's loose policy, Yellen will be the one to end quantitative easing and, eventually, raise short-term interest rates. And those could be an even bigger problem for emerging markets that the initial tsunami.

Yellen's recent confirmation that quantitative easing (QE) will cease in October 2014 is the latest and firmest signal that U.S. monetary policy is reversing direction. The Fed began the year talking about the "tapering" of loose monetary policy, relaxing QE's bond-buying program and potentially raising interest rates. Now a concrete end to QE is on the horizon. The big question that emerging markets are now asking is how quickly and how suddenly interest rates will go up. Following the latest numbers that the United States' GDP grew by 4 percent during the second quarter, some monetary policy hawks are calling for interest-rate hikes soon to cool the economy. That's exactly what emerging markets are worried about.

When U.S. monetary policy tightens, it will wreak financial havoc in some emerging markets. Higher interest rates in the United States will cause capital to flock into the U.S. market and away from developing and emerging-market countries -- drying up credit and sometimes worse. Morgan Stanley has dubbed Brazil, India, Indonesia, South Africa, and Turkey the "fragile five." But it is not just these countries that are worried. No emerging market is completely safe.

The good news for citizens of Turkey, Indonesia, and South Africa is that emerging markets today have more guarantees for their financial security than they've ever had before. These countries today have more tools and facilities at their disposal to offset the knock-on effects of financial developments in the United States and Europe than they did back in 2007 and 2008, when the U.S. financial crisis brought the world to the brink of disaster. Since then, countries across the developing world have created a suite of new derivatives regulations and a family of institutions beyond the International Monetary Fund to draw on to support their currencies. The freshly minted Contingent Reserve Arrangement, a $100 billion lending fund created at the July BRICS Summit in Brazil, is just the latest.

But will emerging markets use these options if a shock occurs when QE ends or interest rates go up in the United States? On paper, the global economy is in a better place than in 2007, but much still needs to be done to ensure that when the United States sneezes, emerging markets don't get the flu. These countries have to boldly regulate financial markets on their own, as they have begun to do. But all the world's major economies need to forge a truly multilateral approach in order to safeguard the global economy.

Rousseff wasn't exaggerating when she said that these policies were unleashing a tsunami of financial flows into her country and others like it, though that wasn't Bernanke's intent. Bernanke kept short- and long-term interest rates low and embarked on QE, purchasing mortgages and other securities, to stabilize asset prices and repair banks' balance sheets. The battery of Fed policies was intended to get banks to lend to people investing in U.S. factories, small businesses, homes, and more. But until recently, banks wouldn't lend because there was too little demand in the U.S. economy to support such activity.

Instead, global banks played the "carry trade." The carry trade is an investment strategy in which a financial actor, usually a hedge fund, borrows dollars at low interest rates and then invests them in a country with a higher interest rate -- emerging markets like Brazil, India, and others in this case. The difference between the two interest rates is the "carry," or the first bit of profit an investor can make.

When carry trade activity occurs in high volumes, however, it appreciates the value of the target country's currency. The surge in capital inflows appreciates emerging markets' exchange rates, making private- and public-sector issuers of debt, equity, and derivatives think they have more international collateral than they really do, thus triggering them to borrow more in foreign currencies. Exporters, who see the cost of their goods go up relative to those of their competitors, and consumers of assets, such as the housing sector, suffer the most.

This is exactly what happened in the wake of the global financial crisis. From 2009 to 2013, countries like Brazil, South Korea, Chile, Colombia, Indonesia, and Taiwan all had lucrative interest-rate differentials and experienced massive surges of capital flows. The interest-rate differential between Brazil and the United States was more than 10 percentage points for a while. It's little surprise that New York hedge funds saw a better bet in Brazilian bonds than investing in the housing market in Nebraska or factories in Ohio. The result was significant currency appreciation -- as much as 40 percent in Brazil from 2009 to 2011 -- and asset bubbles in real estate and stock markets. The same was true in other countries across the developing world.

But if these surges of capital inflows seem bad, the reverse is even worse. And that's what emerging markets are bracing for now.

When interest rates rise in the United States and the rest of the industrialized world, it could trigger a sudden stop of financial flows to emerging market and developing countries, followed by capital flight as investors seeking higher interest rates and safer markets move money back to the industrialized world. This would depreciate emerging markets' currencies. When the holders of all the debt from the surge have to pay their creditors back in foreign currency, their debt burden bloats in proportion with the currency depreciation. Currency depreciation not only jeopardizes the corporate and public sectors' ability to pay down debt, but it also makes consumers angry because they can buy fewer imports. The seeds of downturn or worse are sowed when consumers aren't buying and companies aren't selling enough to pay back external debt. When Yellen announced that QE will end soon, she signaled that this kind of reversal might be exactly what Brazil, Indonesia, and others have in store.

The QE unwinding alone may not trigger these effects. Many investors already have accounted for the inevitable change in U.S. policy. More important is when U.S. interest rates will rise, especially the short-term federal funds rate. Many observers expect them to start going up in mid-2015, though the recent good news for the U.S. economy suggests the rise could be even sooner. A sudden acceleration of that trend could possibly cause a sudden stop in financial flows to emerging markets. When rates are high in the United States and investors get jitters, they flock to the relative safety of the U.S. market. The IMF calculates that just a 5 basis-point increase in U.S. interest rates could cause capital flight out of emerging markets and developing countries worth 0.5 to 1.25 percent of their GDPs.

Emerging markets are bracing for a rate hike in the United States and the effect it will have on their economies. This isn't their first rodeo. U.S. interest-rate hikes in 1980s and 1990s played a role in financial crises across Latin America and East Asia. Over the course of the 1980s, many countries in Latin America and Asia prematurely liberalized their financial markets, often at the encouragement of the United States and the IMF. This opened them up to vulnerabilities of changing interest rates. When the Fed raised rates in the early 1990s, capital flew out of Latin America and Asia more quickly than it came in, beginning what became known as the lost decade.

Just the announcement this year of "tapering" U.S. monetary policy led to capital flight and currency depreciation in Argentina, Chile, Indonesia, South Africa, Brazil, and other emerging markets. A new paper for the National Bureau of Economic Research finds that during the period of 2012 to 2013 -- when the Federal Reserve simply began talking about Yellen's moves -- emerging markets with sound macroeconomic policy, meaning they weren't carrying huge amounts of debt, were affected most negatively.

Currency depreciations in these countries, such as Malaysia, Peru, South Korea, and others, were three times larger than in the countries seen as more "fragile." These findings are striking and telling. The usual story is that if a country has strong macroeconomic policies, such as low foreign debt, it can withstand swings in capital flows. But this paper shows that not to be the case. Predicting the impacts of interest-rate hikes in the United States on emerging markets may be impossible. Growth in emerging markets is already slowing. A deeper, more prolonged hit due to a capital flow reversal would be disastrous.

There is good news though. On some levels, emerging markets are better equipped than they have been in decades to weather the storm. Some countries, such as South Korea, Chile, and Brazil, have developed domestic bond markets denominated in their own currencies, insulating them somewhat from the depreciation impact of a sudden pullout. High commodity prices have also equipped emerging markets with more foreign exchange reserves than they have had in the past. When a currency drops, central banks can buy up their currency with those reserves to prop up its value. Copper-laden Chile, soybean-rich Brazil, and other commodity producers will have some reserves at their disposal, though not every emerging market enjoys this luxury.

Emerging markets have another new safeguard that they lacked in previous crises: Emerging-market central banks have developed a suite of new regulations, passed from 2009 to 2013. In these years, South Korea, Brazil, and others all independently decided to put limits and taxes on derivatives trades in the foreign exchange rate markets. This helped cool off the surge in inflows. These measures add to the tool kit of domestic capital markets, taxes or outright limits on capital flows, and the use of reserves. The IMF found that countries that used measures similar to these were among the least hard hit during the financial crisis.

And there are new sources of funding that might provide insurance. The New Development Bank and its Contingency Reserve Arrangement (CRA), just negotiated in July by the BRICS countries, is the latest in a number of facilities that emerging markets can rely on when things start to go south. The CRA boasts $100 billion in pooled reserves that, in theory, can be used to backstop a currency crisis in emerging markets. There are also a number of similar facilities, such as the Chiang Mai Initiative for Asia and the Latin American Reserve Fund (FLAR). Indeed, Ecuador just received a backstop from FLAR in July.

Emerging markets and developing countries say they prefer domestic measures and these other alternatives to knocking on the IMF's door for funding when crisis hits. From Brazil to South Korea, the IMF has a stigma that will take a long time to shake off after the bad advice the IMF doled out in the financial crises of the 1980s and 1990s. Although the IMF has clearly changed its tune since then, giving up its insistence on so-called structural adjustment policies, many countries in Latin America, Asia, and Africa remember lost decades of IMF policy that was highly costly, both economically and politically.

Despite the new tools at their disposal, there are still not enough weapons in emerging markets' arsenals to safeguard against financial crises. Although many emerging markets have deeper domestic capital markets than they used to, more than 50 percent of emerging-market domestic bonds are held by foreigners who might be more apt to sell off their assets if conditions change.

It is also unclear how quickly the CRA will be set up and whether it will actually be used. Like the CRA, the Chiang Mai Initiative was erected as an alternative to the IMF after the 1997 Asian financial crisis. But when push came to shove, Asian countries turned to Federal Reserve swap lines for funding after the global financial crisis rather than draw on their regional alternative or the IMF. 

Finally, countries with trade and investment treaties with the United States will be hard-pressed to use some of the new regulations on cross-border financial flows. In its free trade agreements and bilateral investment treaties, the United States insists that capital move freely and without delay between parties. Chile, for example, which has a free trade agreement with the United States, may not have such regulations at its disposal, but a country like Brazil can do whatever it wants. Malaysia currently has the policy space to regulate capital flows, but if the United States gets its way in the Trans-Pacific Partnership agreement, it won't for long.

For these reasons, more multilateral approaches to global financial flows are necessary. The burden of regulation should not fall solely on the receiving end of capital inflows. The source countries of that capital have to play a role as well. At very minimum, the Fed should think about and prepare markets for the global consequences of its policies. Even the IMF has joined this chorus calling for a more responsible and reciprocal approach to global capital flows. As some in the IMF are now reminding, this is what its framers had in mind all along. In a December 2012 article, IMF chief economist Olivier Blanchard and his deputy, Jonathan Ostry, argued: "a multilateral perspective is essential. Indeed this was a key tenet of the IMF's founding fathers."

On paper, the broader interests for multilateral cooperation have started to align. If the Unite States seeks to cool its economy by raising rates over the next year, the Fed will not want a surge in inflows from emerging markets to heat things up. Emerging markets, already experiencing slow growth, don't want investment to dry up.

The politics of multilateral coordination of this kind are thorny, to say the least. The Fed's tight mandate is for employment and price stability in the United States, not financial stability across the world. And the financial industry is, to say the least, far from enthusiastic about regulating financial globalization.

So emerging markets will likely be on their own to mitigate the impacts of the Federal Reserve under Janet Yellen. As former U.S. Treasury Secretary John Connally once put it, "The dollar is our currency, but it's your problem."

Photo by JUNG YEON-JE/AFP/Getty Images