Transcript Lecture 2: International Capital Flows

Thorvaldur Gylfason
Joint Vienna Institute/IMF Institute
August 24–September 4, 2009
1. Foreign Trade in Goods and Capital

Analytical framework
2. Financial Globalization

Recent Trends and Crises
3. Recent Experience of Capital
Account Liberalization
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 securities – e.g., equity in
domestic firms – earns foreign
exchange, and also grants access to
capital, ideas, know-how, technology
But financial capital is volatile
Balance of payments
R = X – Z + Fx – Fz = X – Z + F
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
 Portfolio investment
 Foreign borrowing
Trade in goods and services depends on
Relative prices at home and abroad
Exchange rates (elasticity models)
National incomes at home and abroad
Geographical distance from trading
partners (gravity models)
Trade policy regime
Tariffs and other barriers to trade
Again, capital flows consist of foreign
borrowing, portfolio investment, and
foreign direct investment (FDI)
Trade in capital depends on
Interest rates at home and abroad
Exchange rate expectations
Geographical distance from trading
partners
Capital account policy regime
Capital controls and other barriers to free flows
 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.
 Facilitate
borrowing abroad to
smooth consumption over time
Dampen business cycles
 Reduce vulnerability to domestic
economic disturbances

 Encourage
saving, investment, and
economic growth

Increase welfare
Real interest rate
Emerging countries
save a little
Saving
Investment
Loanable funds
Real interest rate
Industrial countries
save a lot
Saving
Investment
Loanable funds
Emerging countries
Industrial countries
Saving
Real interest rate
Real interest rate
Financial globalization encourages investment in emerging
countries and saving in industrial countries
Borrowing
Investment
Loanable funds
Lending
Saving
Investment
Loanable funds
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 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 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)
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 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 losses, exchange rate pressure
 Drastic balance of payments adjustment, with
severe macroeconomic consequences
 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
 Global
cross-border asset and liabilities
accumulation has risen dramatically
over the past 15 years, reflecting
Financial Globalization
 Following relatively narrow fluctuations
1980–95, global cross-border flows
tripled to $6.4 trillion, reaching almost
15% of world GDP by 2005
 Financial crises 1997-98 and 2008-09
550
80
70
450
60
350
50
250
40
30
150
20
50
ala
ys
ia
y
0
M
en
Ar
g
Hu
ng
ar
tin
a
y
ke
Tu
r
a
Ko
re
d
Th
ai l
an
dia
In
sia
In
do
ne
na
Ch
i
zil
Br
a
ex
ico
M
-50
10
Net private capital flows
cumulative share of selected countries as a proportion of total net private capital flows to emerging markets
Source: IMF, World Economic Outlook database.
450
350
USD Bil
250
150
50
-50 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-150
-250
Bank loans and other
Net portfolio investment
Net foreign direct investment
Source: IMF, World Economic Outlook database.
Africa: Net Capital Flows 1980-2008
50
300
40
250
Billions of USD ($)
200
20
150
10
100
0
50
-10
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
Source: IMF WEO
Direct investment, net (left axis)
Other private, net (left axis)
Official capital flows, net (left axis)
Debt Service/Exports of G&S (right axis)
Debt Ratios in Percent (%)
30
Billions of USD ($)
Asia: Net Capital Flows 1980-2008
350
330
310
290
270
250
230
210
190
170
150
130
110
90
70
50
30
10
-10
-30
-50
-70
-90
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Direct investment, net (left axis)
Source: IMF WEO
Other private, net (left axis)
Official capital flows, net (left axis)
Western Hemisphere: Net Capital Flows 1980-2008
100
80
Billions of USD ($)
60
40
20
0
-20
-40
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
-60
Direct investment, net (left axis)
Source: IMF WEO
Other private, net (left axis)
Official capital flows, net (left axis)
Middle East: Net Capital Flows 1980-2008
90
40
Billions of USD ($)
-10
-60
-110
-160
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
-210
Direct investment, net
Source: IMF WEO
Other private, net (left axis)
Official capital flows, net
 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
FDI has become a dominant source of
private capital flows to emerging market
economies; equity flows have also risen
in importance; debt flows have declined
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
(Giudotti-Greenspan Rule)
Mismatches
 Maturity mismatches (borrowing short, lending
long)
 Currency mismatches (borrowing in foreign
currency, lending in domestic currency)
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 reflect 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)
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
 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

 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- to longerterm 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)
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

E.g., Iceland 2008
 Market-based
controls, such as
unremunerated required reserves, are
preferable to administrative measures
 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
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 sound policies as well as effective
institutions, including financial supervision,
and good timing