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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