Download Controlled Capital Account Liberalization

Controlled Capital Account Liberalization
Eswar Prasad & Raghuram Rajan
IMF
Plan of Talk

Reserve accumulation—how much, why, and
cost-benefit issues

Approaches to sterilization

Other approaches to dealing with inflows

The Prasad-Rajan proposal


The proposal in the broader context of new
literature on financial globalization
China and India as illustrations
China Foreign Exchange Reserves: Flows and Stocks
40
1000
900
35
800
30
25
600
Monthly changes
Stock of reserves (RH)
20
500
400
15
300
10
200
5
100
0
Jan-95
0
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
(in billions of USD)
(in billions of USD)
700
India Foreign Exchange Reserves: Flows and Stocks
8
160
Monthly changes
6
140
Stock of reserves (RH)
120
100
2
80
0
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
60
-2
40
-4
-6
20
0
(in billions of USD)
(in billions of USD)
4
Why the Build-up of Reserves?

Capital flows to emerging markets

Speculative inflows

Current account surpluses

Oil revenues
China: Reserve Accumulation and its Components
250
Reserve accumulation
200
Current account balance
Net FDI
150
USD billion
Net non-FDI capital inflows plus errors and omissions
100
50
0
-50
-100
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
India: Reserve Accumulation and its Components
40
160
140
30
120
20
10
Private capital flows
(Left axis)
80
60
0
-10
-20
2000Q1
40
Reserves
(Right axis)
2000Q4
2001Q3
Current account balance
(Left axis)
2002Q2
2003Q1
2003Q4
2004Q3
20
0
2005Q2
USD billion
USD billion
100
Benefits of Reserve Accumulation

Reduced vulnerability to crises

Mitigates real exchange rate appreciation

Lowers external borrowing costs
Costs of Reserve Accumulation

Complications for macroeconomic
management

Adjustment may come through inflation

Opportunity cost of holding reserves

Quasi-fiscal costs of sterilization

Domestic policy distortions
Sterilization: Instruments/Methods

Repos, open market operations

Central Bank securities

Fx swaps

Government deposits at the Central Bank

Reserve requirements
China: Stocks of Reserves and Central Bank Bills
(in billions of RMB)
7000
6000
Foreign Exchange Reserves
Stock of Outstanding PBC Bills
5000
4000
3000
2000
1000
0
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
India: Stock of Reserves and Sterilization Instruments
1,200
160
Govt Securities
1,000
140
Repos
Stock of foreign exchange reserves
(RHS)
600
(in billions of USD)
120
MSB
100
400
80
200
60
0
40
Jan-02
Apr-02
Jul-02
Oct-02
Jan-03
Apr-03
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
-200
20
-400
0
(in billions of USD)
800
China: PBC Bill Rates vs. U.S. Treasury Yields
5.0
4.5
4.0
U.S. rates
3.5
3.0
2.5
2.0
PBC rates
1.5
1.0
0.5
PBC 3-month
PBC 1-year
U.S. 3-month
U.S. 3-year
0.0
Apr-03
Oct-03
Apr-04
Oct-04
Apr-05
Oct-05
India Domestic Bond Yields vs. U.S. Treasury Yields
7.0
6.0
India Rates
5.0
4.0
3.0
2.0
India Govt Securities - 1 year
U.S. Rates
India Repo Rate
U.S. 3-month
1.0
U.S. 3-year
0.0
Apr-03
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
What Are Countries Doing with Reserves?
Actions and Proposals

U.S. bonds (Treasury and Agency)

Other industrial country treasury paper

Bank recapitalization (China)

Infrastructure investment (India)

Korea Investment Corporation
Improving Risk-Return Profile of Reserves




Diversify into non-U.S. $ denominated
instruments, gold
Regional pooling of reserves—e.g., Asian
Investment Corporation (Genberg et al.)
Invest reserves in broader range of
instruments including foreign equities
Asset management by IMF and World Bank
(Summers)
Other Policy Actions

Tighter controls on inflows

Liberalization of outflows:
• Firms (retain fx earnings, borrow in fx)
• Households
• Institutional investors (QDII)
Is There a Way to Do Better?
How to Achieve Multiple Objectives?
• Get benefits of inflows
• Reduce costs of sterilization and fx
exposure of Central Banks
• Lower risks of capital account liberalization
The Prasad-Rajan Proposal
Inflows
Reserves
$
$
Central
Bank
RMB
Liquidity
RMB
CB Bills
Inflows
Investments
Controlled Outflows:
$
$
Quantity + Timing
$
Central
Bank
Closed-end
RMB
Mutual Fund
Financial Market
RMB
Liquidity
Development
RMB
Shares
International Portfolio
Diversification
Sterilization
Other Benefits




Provides breathing room for some
macroeconomic reforms (fx flexibility)
Fx risk taken off Central Bank’s balance sheet
Securitizing inflows may facilitate reduction in
external borrowing costs
Could complement other approaches such as
QDII
Potential Concerns

Could delay more fundamental reforms

Governance problems

Multiple exchange rates

Rents to mutual funds if excess demand for
securities

Fx risk transferred to households

No demand for securities if expectation of
currency appreciation
The Proposal in a Broader Context
The Macroeconomic Implications Of
Financial Globalization:
A Reappraisal And Synthesis
Ayhan Kose, Eswar Prasad, Kenneth Rogoff, Shang-Jin Wei
The Traditional View
More efficient international
allocation of capital
Financial
Globalization
Capital deepening
GDP growth
Csmn. volatility
International risk sharing
A Different Perspective
Financial
Globalization
Financial market development
Institutions, governance
Macroeconomic discipline
Competition
Collateral Benefits
GDP growth
Csmn. volatility
Factors that Influence Outcomes of
Financial Integration: Threshold Effects

Financial Sector Development

Institutions, Governance

Macro Policies

Trade Openness

Exchange Rate Regime
TENSION !!


Financial integration helps developing
countries to improve their financial
markets, enhance governance, impose
discipline on macro policies, break power
of interest groups that block reforms, etc.
But, in the absence of a basic pre-existing
level of these supporting conditions,
financial integration can wreak havoc
What’s a Country to Do?



Trade integration to begin with; but often
results in de facto financial integration.
Works okay, but not ideal substitute
Collateral benefits perspective can guide
country-specific sequencing of capital
account opening
Controlled capital account liberalization if
experiencing inflows, external circumstances
favorable