Transcript Capital Account Liberalization and Vulnerabilities in Emerging

Course on External Vulnerabilities and Policies
Tunis, March 2–13, 2009
Thorvaldur Gylfason
1. Financial Globalization

Recent Trends and Implications for
Emerging Markets
2. Policy Responses in Emerging
Market Economies
3. Recent Experiences of Capital
Account Liberalization
 Since
early 1990s, capital inflows (i.e.,
foreign financial resources obtained by the
domestic private and public sectors) have
become a large source of financing for
many emerging market economies
 The lecture aims at
Analyzing vulnerabilities associated with large capital
flows in emerging market countries
 Discussing policy responses by recipient countries
 Examining arguments in favor of a gradualist
approach to liberalization of capital flows

Capital mobility
A stylized view of capital mobility 1860-2000
First era of
international
financial
integration
Return toward
financial
integration
Capital
controls
Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.
The case for free trade in goods and
services applies also to capital
Trade helps countries to specialize
according to comparative advantage,
exploit economies of scale, and
promote competition
Exporting equity in domestic firms not
only earns foreign exchange, but also
secures access to capital, ideas, knowhow, technology
But financial capital is volatile
Facilitate borrowing abroad to
smooth consumption over time
Dampen business cycles
Reduce vulnerability to domestic
economic disturbances
Increase risk-adjusted rates of return
Encourage saving, investment, and
economic growth
Private
capital flows
to SubSaharan
African
countries,
though still
small in
dollar terms,
are rising and
can be
significant in
relation to
the recipient
country GDP
1
 Global
cross-border asset and
liabilities accumulation has risen
dramatically over the past 15 years,
reflecting Financial Globalization
 After a period of relatively narrow
fluctuations 1980–95, global crossborder flows tripled to $6.4 trillion,
reaching almost 15% of world GDP by
2005
550
80
70
450
60
350
50
250
40
30
150
20
50
ala
ys
ia
y
0
M
en
Ar
g
Hu
ng
ar
tin
a
y
ke
Tu
r
a
Ko
re
d
Th
ai l
an
dia
In
sia
In
do
ne
na
Ch
i
zil
Br
a
ex
ico
M
-50
10
Net private capital flows
cumulative share of selected countries as a proportion of total net private capital flows to emerging markets
Source: IMF, World Economic Outlook database.
450
350
USD Bil
250
150
50
-50 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-150
-250
Bank loans and other
Net portfolio investment
Net foreign direct investment
Source: IMF, World Economic Outlook database.
Source: IMF WEO, Oct. 2007, Chapter 3, Figure 3.2.
(Percent of Emerging Market GDP)
14
Emerging
markets, as a group, have
become net exporters of capital and
an important investor class in
mature markets
Emerging markets’ outflows mirror
the U.S. external financing gap
The flow of capital from emerging to
mature markets is channeled in
large part through Asian central
bank reserves and sovereign wealth
funds
• First wave
of private
capital
inflows to
EMs ended
abruptly
with the
Asian crises
in 1997-98
• Second
wave after
2002
By private
capital flows is
meant flows into
the recipient
sector, not from
the source
sector (the
investor)
Only changes in foreign assets
and liabilities of the domestic
private sector, as recorded in
the BOP, are included in the
data
FDI has become the dominant source of
private capital flows to emerging market
economies; equity flows have also risen
in importance; debt flows have declined
Capital flows result from interaction
between supply and demand
 Capital
is “pushed” away from
investor countries

Investors supply capital to recipients
 Capital
is “pulled” into recipient
countries

Recipients demand capital from investors
External factors “pushed” capital
from industrial countries to LDCs
 Cyclical
conditions in industrial
countries
 Recessions in the early 1990s
 Decline in world interest rates
 Structural
countries
changes in industrial
 Financial structure developments
 Demographic changes
 Institutional
investors, banks, and firms
in mature markets increasingly invest in
emerging markets assets to diversify and
enhance risk-adjusted returns (i.e., to
reduce “home bias”), owing to



Low interest rates, high liquidity in mature
markets, stimulus from “yen” carry trade
Demographic changes, rise in pension funds
in mature markets
Changes in accounting and regulatory
environment allowing more diversification of
assets
 Institutional
investors, banks, and firms
in mature markets increasingly invest in
emerging markets assets to diversify and
enhance risk-adjusted returns (i.e., to
reduce “home bias”), owing to


Sovereign wealth funds (e.g., future
generations funds) need to invest abroad as
the domestic financial market is too small
Need to invest the windfall gains accruing to
commodity producers, in particular oil
producers (e.g., Norway)
Internal factors “pulled” capital
into LDCs from industrial countries
 Macroeconomic
fundamentals
 Reduction in barriers to capital flows
 Private risk-return characteristics
 Creditworthiness
 Productivity
Structural



Better financial market infrastructure
Improved corporate and financial sector
governance
More liberal regulations regarding foreign
portfolio inflows
Stronger



changes in emerging markets
macroeconomic fundamentals
Solid current account positions (except in
emerging European countries)
Improved debt management
Large accumulation of reserve assets
Improved
allocation of global savings
(allows capital to seek highest returns)
Greater efficiency of investment
More rapid economic growth
Reduced macroeconomic volatility
through risk diversification (which
dampens business cycles)
 Income
smoothing
 Consumption smoothing
 Open
capital accounts may make receiving
countries vulnerable to foreign shocks
 Magnify domestic shocks and lead to contagion
 Limit effectiveness of domestic macro policy
instruments
 Countries
with open capital accounts are
vulnerable to
 Shifts in market sentiment
 Reversals of capital inflows
 May
lead to macroeconomic crisis
 Sudden reserve loss, exchange rate pressure
 Excessive BOP and macro adjustment
 Financial crisis
 Overheating
of the economy
 Excessive expansion of aggregate demand
with inflationary pressures, real exchange
rate appreciation, widening current account
deficit
 Increase in consumption and investment
relative to GDP
 Quality of investment suffers
 Construction booms
Monetary consequences of capital inflows
and accumulation of foreign exchange
reserves depend on exchange regime
6
0
0
1
,
6
0
0
Chile 1978-81
1
,
4
0
0
5
0
0
1
,
2
0
0
Mexico
4
0
0
1
,
0
0
0
Venezuela
Chile 1989-94
8
0
0
3
0
0
6
0
0
2
0
0
4
0
0
Sweden
Finland
2
0
0
1
0
0
0
0
3 2 1 0
1
2
3
4
5
6
2
0
0
7
Year with respect to start of Inflow period
Note: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the
1980s and 1990s and for Venezuela is shown on the right.
Source: World Bank (1997)
Source: IMF WEO, Oct. 2007, Chapter 3, Table 3.1.
Large deficits
 Current account deficits
 Government budget deficits
Poor bank regulation
 Government guarantees (implicit or explicit),
moral hazard
Stock and composition of foreign debt
 Ratio of short-term liabilities to foreign reserves
Mismatches
 Maturity mismatches (borrowing short, lending
long)
 Currency mismatches (borrowing in foreign
currency, lending in domestic currency)
Asian reserves are now higher than
necessary to cover short-term debt
Mexico,
Korea,
Mexico,
Thailand,
Venezuela,
Turkey,
Venezuela,
Argentina,
Malaysia,
Indonesia,
Argentina,
'93-95
'96-97
'81-83
'96-97
'87-90
'93-94
'92-94
'88-89
'86-89
'84-85
'82-83
12% of GDP
9% of GDP
18% of GDP
15% of GDP
11% of GDP
6% of GDP
10% of GDP
7% of GDP
10% of GDP
5% of GDP
4% of GDP
0
10
20
30
40
Billion dollars
Source: Finance and Development, September 1999.
50
60
 External
or financial crisis followed capital
account liberalization

E.g., Mexico, Sweden, Turkey, Korea, Paraguay
 Response
Rekindled support for capital controls
 Focus on sequencing of reforms

 Sequencing
makes a difference
Strengthen financial sector and prudential framework
before removing capital account restrictions
 Remove restrictions on FDI inflows early
 Liberalize outflows after macroeconomic imbalances
have been addressed

High
degree
of risk
sharing
Portfolio
equity
Foreign
direct
investment
Short
term
debt
Long term
debt
(bonds)
No risk
sharing
Transitory
Permanent
Pre-conditions for liberalization
Sound macroeconomic policies
Strong domestic financial system
Strong and autonomous central bank
Timely, accurate, and comprehensive
data disclosure
Capital
flows exhibit volatility and a
“boom-bust” pattern
The pattern reflects in part waves of
privatization (FDI) and liberalization
in emerging market economies
But it can at times reflects contagion
effects from a financial crisis across
markets
 High
volatility episodes can be
associated with temporary loss of
access to capital markets and high
yields on emerging markets bonds
 The loss of access often reflects
adverse political or economic
developments in emerging market
economies
 The loss of access is sometimes
linked to developments in mature
markets (e.g., tightening of liquidity)
 There
appears to be a significant
procyclical element to international capital
market access for emerging markets
 International investors are willing to lend
to emerging markets in good times, but
tend to pull back in bad times, thereby
amplifying swings in the domestic economy
(“sudden stops”)
 Pulling back has been linked to sharp falls
in GDP and consumption in emerging
markets
Foreign
Direct Investment (FDI) is
considered the most stable capital
flow to emerging markets
Experience shows that FDI in general
continued to grow through capital
account crisis episodes
 Financial
globalization is often blamed for
crises in emerging markets

It was suggested that emerging markets had
dismantled capital controls too hastily, leaving
themselves vulnerable
 In
a more radical way, some prominent
economists view unfettered capital flows
as disruptive to global financial stability
These economists call for capital controls and
other curbs on capital flows (e.g., tax)
 Others argue that increased openness to
capital flows has proved essential for countries
seeking to rise from lower-income to middleincome status

 There
is little formal empirical evidence
to support the claims that globalization
has led to financial crises
 Macroeconomic evidence of the benefits
of financial globalization is elusive, too
 An alternative theoretical approach was
proposed by IMF staff:

In addition to traditional benefits, there is a
broad set of "collateral benefits“ — financial
market development, better institutions and
governance, and macroeconomic discipline
The threshold, though difficult to define, signals the
need for institution building in emerging markets as a
requirement to full capital account opening
2
Defining a Sensible Policy Response to
Large Capital Inflows
The “impossible trinity” suggests
that, with an open capital account,
countries facing large capital inflows
need to choose between nominal
appreciation and higher inflation
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate
(as in US)
Monetary
union
(as in EU)
FIXED
EXCHANGE
RATE
Capital controls
MONETARY
INDEPENDENCE
In view of benefits and costs, no single
exchange rate regime is right for all
countries at all times
The regime of choice depends on time
and circumstance
• If inefficiency and slow growth are the
main problem, floating rates can help
• If high inflation is the main problem,
fixed exchange rates can help
No national currency
Other types of fixed rates
Dollarization
Currency board
Crawling pegs
Bilateral fixed rates
Managed floating
Pure floating
17%
23
5
4
3
3
26
19
100
49%
51%
There is a gradual tendency towards floating, from 10% of LDCs
in 1975 to over 50% today
 Impact
of inflows at home could be limited
by allowing exchange rate to absorb the
pressures



Revalue currency under a fixed regime
Allow currency to appreciate in a flexible regime
Move from fixed exchange rate system to greater
flexibility (changes in rate of crawl, band width,
etc.)
 Allowing
exchange rate appreciation may be
constrained by competitiveness concerns

Real appreciation may be unavoidable

Choice between real appreciation through nominal
exchange rate or higher inflation
 Greater
exchange rate flexibility, by
introducing two-way exchange rate risk,
would also help banks and firms to assess
better their foreign exchange risks and limit
a buildup of open foreign exchange positions
 Fixing
the exchange rate invites private
sector to bet against authorities if the
capital account is open
 It is theoretically possible to have an open
capital account and a fixed exchange rate,
but then monetary policy can only be
devoted to maintaining the fixed rate
 Domestic and foreign shocks are easier to
deal with if exchange rate is flexible
enough to absorb part of the strain, rather
than imposing all the adjustment on
domestic wages and prices, and quantities
1/ Governor, Bank of Israel and former First Deputy Manager of the IMF
 Typically,
fiscal policy in emerging market
economies is procyclical, contributing to
overheating the economy receiving large
capital inflows
 Fiscal tightening may help to moderate
overheating pressures from the inflows
 Fiscal restraint during periods of large
capital inflows would allow lower interest
rates and alleviate in part the appreciation
pressure on the currency
 It would also allow more scope for
countercyclical fiscal policy when the
inflows slow down
 Resisting
nominal and real appreciation by
sterilizing inflows cannot generally be
sustained for long by Central Bank

Resistance to nominal appreciation is
generally unable to prevent real appreciation
through higher inflation in the medium tem
 Faced
with sustained inflows, Central
Bank should move to a more flexible
exchange rate
 Maintaining fiscal restraint in periods of
buoyant revenues is crucial
 Raising the quality of the domestic
financial market, including regulatory
institutions and the rule of law, increases
the level and reduces the volatility of
capital inflows
 Controls
on capital account
transactions aim to reduce risks
associated with fluctuations in inflows
or outflows
Specific objectives may include
 Protecting
a fragile banking system’s
viability
 Avoiding quick reversals of short-term
capital inflows following an adverse
macroeconomic shock
 Reducing currency appreciation when
faced with large inflows
 Inducing a shift from shorter- to longerterm inflows
 Administrative

Outright bans, quantitative limits, approval
procedures
 Market-based



controls
Dual or multiple exchange rate systems
Explicit taxation on external financial
transactions
Indirect taxation

E.g., unremunerated reserve requirement
 Distinction


controls
between
Controls on inflows and controls on outflows
Controls on different categories of capital
inflows
 The
IMF (which has jurisdiction over current
account, not capital account, restrictions)
maintains detailed compilation of member
countries’ capital account restrictions
 The information in the AREAER has been
used to construct measures of financial
openness based on a 1 (controlled) to 0
(liberalized) classification
 They show a trend toward greater financial
openness during the 1990s
 But these measures provide only rough
indications because they do not measure
the intensity or effectiveness of capital
controls (de jure versus de facto measures)
Implementation
and circumvention
 Controls
distort behavior, as parties try
to evade them
 Controls reduce competition, and may
promote cronyism
 Higher capital costs, esp. for small firms
 Controls may reduce FDI as well as other
inflows
Hard
to sustain controls over long
periods

Investors learn how to evade them
 There


is some evidence that
Capital controls can help preserve some degree
of monetary autonomy
Some countries have succeeded in using capital
controls to alter the maturity of capital flows
 There
may be a case for imposing controls
as an emergency measure during a limited
period if the administrative capacity to
manage controls is there
 Market-based controls, such as
unremunerated required reserves, are
preferable to administrative measures
A
possible strategy is to accept the
risks and try to control them as much
as possible
History and international experience
provide a guide to the liberalization
process
Sound domestic policies and
institutions, including regulatory
framework promoting a strong
financial sector, greatly improve the
chances of ensuring that capital flows
foster sustainable growth
 In
OECD countries, legacy of controls from
1930s and from World War II took long to
disappear
 In France, it took until late 1980s to abolish
capital controls, and in the UK, capital
controls were abandoned only in early 1980s
 It took long in part because of fear that any
change in the system would be destabilizing
 However, it was understood within the
European common market and later EU that
capital mobility was essential to economic
integration
 Since
1944, IMF has had full surveillance
jurisdiction over the current account
 IMF moved close to reaching an agreement
in 1997 on an amendment to its Articles of
Agreement giving the Fund full surveillance
jurisdiction over the capital account as
well
 After Asian crisis, the move to amend the
Articles weakened, and was shelved
 IMF today follows an eclectic and
integrated approach toward capital
account liberalization, emphasizing proper
sequencing and phasing combined with
several concomitant reforms
 IMF’s approach is flexible, recognizing
specific country circumstances
Experience
has shown that a country
with a poor macroeconomic situation,
or a weak financial system, should
not liberalize
It is necessary to create a reasonably
stable banking and financial system
before implementing a meaningful
liberalization
 As this takes a lot of time and effort,
capital account liberalization should be
gradual

Experience suggests
Sequencing by type of capital flow by
liberalizing …



Inflows before or at the same time as outflows
Long-term capital flows before short-term flows
FDI before portfolio investment
Sequencing by sector by liberalizing …



First, the business sector,
Second, individuals,
Third, financial sector
However, not easy to devise an operational
plan that puts these principles in practice
India’s
gradualist approach to
capital account convertibility
 Since
1997, process of capital account
liberalization has been gradual
 Several macroeconomic, institutional,
and market preconditions for progress
in capital account liberalization were
set in terms of fiscal, financial, and
inflation indicators
3

Controls applied more strictly for









Outflows than inflows
Residents than nonresidents
Banks than institutional investors
Individuals than corporations
FDI encouraged by easing approval procedures
Access to external long-term borrowing limited to firms
and development financial institutions
Short-term borrowing is strictly controlled, except for
trade-related purposes
Liberalization of capital outflows has just begun
Significant liberalization on outflows depends on a
comfortable level of foreign exchange reserves and
greater two-way movement in the exchange rate
 Steps
have been taken to manage the
increasing capital inflows






Increased exchange rate flexibility
Phased liberalization of policy framework in relation
to current as well as capital accounts
Flexibility to firms on prepayment of external
commercial borrowings
Allowing banks to invest liberally abroad in highquality instruments
Liberalizing requirements for exporters to surrender
foreign exchange earnings
In the context of domestic liquidity management,
sterilizing excess inflows without significant fiscal
impact
 Turkey’s
open capital account facilitated
extensive use of foreign firms
 Households became heavily dollarized
 Crawling peg adopted in 1999 raised
incentives for banks and firms to increase
their net foreign indebtedness
 Lira was floated in February 2001, leading
to sharp depreciation as foreign creditors
reduced credit rollover
 The depreciation and parallel rise in
interest rates inflicted heavy losses on
balance sheets with large currency and/or
maturity mismatches
The government responded by
 Selling foreign reserves on the market
 Swapping lira bonds held by banks for foreigncurrency linked bonds
 Recapitalizing banks
 Introducing a deposit guarantee
 To secure foreign currency, government borrowed
substantially from official external creditors,
including IMF
These
policies amounted to
transferring foreign currency risk to
government
Capital
flows can play an important
role in economic growth and
development
 But
they can also create macroeconomic
vulnerabilities
Recipient
countries need to manage
capital flows so as to avoid hazards

Need to consider their potential impact on
 Competitiveness
 Risks linked to volatility
 External debt sustainability