Transcript Lecture 3: Capital Account Liberalization and Crises

Thorvaldur Gylfason
IMF Institute/Joint Vienna Institute
Course on Macroeconomic Management and
Natural Resource Management
Vienna, 31 January - 11 February 2011
Capital flows and crises
1.
2.
3.
4.
5.
6.
7.
8.
Costs and benefits
Conceptual framework
History
Recent trends
Causes and effects
Crises
Liberalization
Capital controls
 Definition
o
o
International capital movements refer to flows
of financial claims between lenders and
borrowers
Lenders give money to borrowers to be used now
in exchange for IOUs or ownership shares
entitling them to interest and dividends later
 International
trade in capital allows for
Specialization, like trade in commodities
o Intertemporal trade in goods and services
between countries
o International diversification of risk
o
The case for free trade in goods and
services applies also to capital
Trade in capital 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
The balance of payments
R = X – Z + F
where
R = change in foreign reserves
X = exports of goods and services
Z = imports of goods and services
F = FX – FZ = net exports of capital
Foreign direct investment (net)
Portfolio investment (net)
Foreign borrowing, net of amortization
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
Sudden inflows of capital, e.g.,
following capital account
liberalization, impact economy like
natural resource booms
Currency appreciates
Volatility
Public expenditure expands
Immunization becomes necessary
Stabilization
Capital controls
Emerging countries
save a little
Real interest rate
Saving
Investment
Loanable funds
Real interest rate
Industrial countries
save a lot
Saving
Investment
Loanable funds
Emerging countries
Industrial countries
Financial globalization encourages investment in emerging
countries and saving in industrial countries
Real interest rate
Real interest rate
Saving
Borrowing
Investment
Loanable funds
Lending
Saving
Investment
Loanable funds
 Since
1945, trade in goods and services
has been gradually liberalized (GATT,
WTO)
 Big
exception: Agricultural commodities
 Since
1980s, trade in capital has also
been freed up
 Capital
inflows (i.e., foreign funds obtained
by the domestic private and public sectors)
have become a large source of financing for
many emerging market economies
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.
16
Source: IMF WEO, Oct. 2007, Chapter 3, Figure 3.1.
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.
3
3
2
1
1
0
-1
-1
-2
Direct investment, net (left axis)
Other private, net (left axis)
Official capital flows, net (left axis)
Direct investment/GDP (right axis)
Other private/GDP (right axis)
Official capital/GDP (right axis)
09
20
08
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
20
99
20
98
19
97
19
96
19
19
95
19
94
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
19
83
19
82
Source: IMF WEO
19
19
19
19
81
-2
In Percent of GDP (%)
2
80
Billions of USD ($)
700
650
600
550
500
450
400
350
300
250
200
150
100
50
0
-50
-100
-150
-200
-250
-300
-350
-400
200
175
125
100
75
Debt Ratios in Percent (%)
150
50
25
0
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
Billions of USD ($)
700
650
600
550
500
450
400
350
300
250
200
150
100
50
0
-50
-100
-150
-200
-250
-300
-350
-400
Source: IMF WEO
Direct investment, net
Other private, net (left axis)
Official financial flows, net
Debt/GDP (right axis)
Debt/ Exports of G&S (right axis)
Debt Service/Exports of G&S (right axis)
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
Internal factors “pulled” capital into LDCs
from industrial countries
 Macroeconomic fundamentals in LDCs
 More productivity, more growth, less inflation
 Structural reforms in LDCs
 Liberalization of trade
 Liberalization of financial markets
 Lower barriers to capital flows
 Higher
ratings from international agencies
External factors “pushed” capital from
industrial countries to LDCs
 Cyclical conditions in industrial countries
 Recessions in early 1990s reduced investment
opportunities at home
 Declining world interest rates made IC investors
seek higher yields in LDCs
 Structural
changes in industrial countries
 Financial structure developments, lower costs of
communication
 Demographic changes: Aging populations save more
 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 at home, 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 or
too risky
Need to invest the windfall gains accruing to
commodity producers, in particular oil
producers (e.g., Norway)
 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 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
macroeconomic 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 macroeconomic adjustment
 Financial crisis
 Overheating
of the economy
 Excessive expansion of aggregate demand
with inflation, real currency appreciation,
widening current account deficit
 Increase in consumption and investment
relative to GDP
 Quality of investment suffers
 Construction booms – count the cranes!
 Monetary
consequences of capital inflows
and accumulation of foreign exchange
reserves depend on exchange regime
 Fixed exchange rate: Inflation takes off
 Flexible rate: Appreciation fuels spending boom
Source: IMF WEO, Oct. 2007, Chapter 3, Table 3.1.
Increase in quasi-fiscal deficit
Following from sterilization operations by central
bank
Expansion in bank lending
To finance consumption and investment booms
Reduced loan quality
Increased maturity mismatch and foreign
exchange mismatch in bank balance sheets
Bidding up of asset prices: Bubbles
Including those of stock market and real estate,
especially in urban financial centers
6
0
0
1
,
6
0
0
Chile 1978-81
Mexico
1
,
4
0
0
5
0
0
1
,
2
0
0
Venezuela
4
0
0
1
,
0
0
0
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).
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 (borrow short, lend long)
 Currency mismatches (borrow in foreign
currency, lend in domestic currency)
140
120
100
80
60
40
20
0
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
High
degree
of risk
sharing
Portfolio
equity
Foreign
direct
investment
Short
term
debt
Long term
debt
(bonds)
No risk
sharing
Transitory
Permanent
 Capital
controls aim to reduce risks
associated with excessive inflows or
outflows
Specific objectives may include
 Protecting a fragile banking system
 Avoiding quick reversals of short-term
capital inflows following an adverse
macroeconomic shock
 Reducing currency appreciation when
faced with large inflows
 Stemming currency depreciation when
faced with large outflows
 Inducing a shift from shorter-term to
longer-term inflows
 Administrative

Outright bans, quantitative limits, approval
procedures
 Market-based



controls
Dual or multiple exchange rate systems
Explicit taxation of 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
 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)

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

Pre-conditions for liberalization
Sound macroeconomic policies
Strong domestic financial system
Strong and autonomous central bank
Timely, accurate, and comprehensive
data disclosure
 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
 More
radically, some 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., taxes)
 Others argue that increased openness to
capital flows has proved essential for countries
seeking to rise from lower-income to middleincome status

These slides will be posted on my website:
www.hi.is/~gylfason
 Aid
and other capital flows can play an
important role in the growth and
development of recipient countries …

… but they can also create vulnerabilities
 Recipient
countries need to manage aid
and other capital flows so as to avoid
hazards
Need to consider potential impact of capital
inflows on competitiveness, constraints to aid
absorption, and risks linked to aid volatility
and to external debt sustainability
 Need sound policies and effective institutions,
incl. financial supervision, and good timing
