Download Capital Flows to Emerging Market Economies

Capital Flows to Emerging Market Economies
Forecast,Analysis and Policy Recommendations
April 2011
February 22, 2011
Capital Flows to Emerging Market Economies
Overview:
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Net private capital inflows to emerging economies are estimated to have been $908 billion in 2010, which is 50% higher
than in 2009.
Private flows are projected to increase to $960 billion in 2011 and is $1009billion in 2012.
The 2010 estimate is $83 billion greater than in October and $187 billion higher than the projection a year ago.
Rising flows are supported by strong emerging market fundamentals, long-term investor portfolio rebalancing and
abundant global liquidity.
Resurgent capital inflows raise important policy questions; most emerging economies need tighter monetary policy but
would also benefit from tighter fiscal and macroprudential policies, and allowing more currency appreciation.
For emerging Asia, Inflows this year and next are likely to average around $430 billion, with the region again accounting
for more than 40% of ... flows to emerging markets.
Flows of foreign direct investment should exceed $150 billion a year, more than half of which will go to China and $36
billion to India. Foreign purchases of domestic stocks should stabilize at around $120 billion a year, again dominated by
China and India.
In the past year, the world has seen another boom, with a tsunami of capital, portfolio equity and fixed-income
investments surging into emerging-market countries perceived as having strong macro-economic, policy and financial
fundamentals.
Such inflows are driven in part by short-term cyclical factors (interest-rate differentials and a wall of liquidity chasing
higher-yielding assets as zero policy rates and more quantitative easing reduce opportunities in the sluggish advanced
economies).
Add to the mix of factors behind the inflows are Longer-term secular factors such as emerging markets’ long-term growth
differentials relative to advanced economies; investors’ greater willingness to diversify beyond their home markets; and
the expectation of long-term nominal and real appreciation of emerging-market currencies.
Capital Controls: A reversal of Policy
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The IMF has reversed its position and is allowing developing countries under some
circumstances to control the free flow of capital to protect their economies.
This very pragmatic view is a product of a new policy framework outlined by the fund to use
policy tools like taxes, interest rates to curb the flows of cash in and out of countries.
EM should try to deepen their capital markets to help absorb cash inflows and prevent surges
from causing damaging distortions in their economies.
Since that takes time, however, governments should adjust monetary or fiscal policies as the
first line of defense, such as by boosting the value of their currencies, buying foreignexchange reserves, adjusting interest rates and tightening budget.
The framework also lays the foundations for the Group of 20 industrial and developing nations
as they devise a "code of conduct" on capital controls.
The main concern is that the treatment of capital-flow issues will be based on a biased
approach and deficient analysis. The new framework could also be viewed as a tool for the
IMF to heighten surveillance of emerging markets.
February 22, 2011
Capital Flows: Analysis and Empiric
International Financial Integration
• Capital Flows to Developing Countries
• An international debt cycle.
• Reasons for flows to emerging markets in the 1990s & 2000s.
• Pros and Cons of Open Financial Markets
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Advantages
• The theory of intertemporal optimization
• Other advantages
Disadvantages of financial integration
• Procyclical capital inflows
• Periodic crises
stop (Asia crisis)
1st
2nd boom
boom
start
3rd boom
start
stop
(international debt crisis)
(recycling
petro-dollars)
start
Three booms in capital flows to developing countries
Capital Flows: Dissecting The Causes

Domestic Economic
Reforms
External factors
Cross-border factors
Econominc.
Liberalization
 Privatization
 Monetary
stabilization
 Removal of
capital controls
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
pro-market environment
assets for sale
higher returns
open to inflows
More of Northern portfolios in mutual funds
 New vehicles: country funds, ADRs
 Brady Plan lifted debt overhang of 1980s
 Moral hazard from earlier bailouts
The third
emerging
market
boom
began in
2003.
Between 2003-07, emerging markets used the inflows to build up
Forex Reserves rather than to finance Current Account Deficits
7.00
6.00
5.00
4.00
in % of GDP
(Low- and middleincome countries)
1980-2006
Net Capital
Flow
Change in
Reserves
% of GDP
3.00
2.00
1.00
0.00
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
-1.00
-2.00
-3.00
-4.00
Current
Account
Balance
In the early
1990s,
portfolio
investment
dominated.
This time
(2003-07)
Foreign
Direct
Investment
(FDI) was
bigger.
Both China and India used reserve accumulation to finance
Capital inflows
Latin America ran CA surpluses
and added to reserves
Central/Eastern Europe is the one emerging markets group that ran
worrisome current account deficits, esp. Hungary, Ukraine, Latvia...
February 22, 2011
Advantages of financial opening in emerging-market countries
• Investors in richer countries can earn a higher return on their saving by investing in
the emerging market than they could domestically
• Everyone benefits from the opportunity to diversify away risks and smooth
disturbances
• Letting foreign financial institutions into the country improves the efficiency of
domestic financial markets.
• Governments face the discipline of the international capital markets in the event they
make policy mistakes
February 22, 2011
Assessing The effects of opening stock Markets to foreign investors
Cost of Equity capital falls.
February 22, 2011
Assessing The effects of opening stock Markets to foreign investors
Rate of capital formation rises
THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT
ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL BORROWING
=> domestic residents borrow
from abroad, so that they
can consume more in Period 0.
THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT,
AND WELFARE GAINS FROM INTERNATIONAL BORROWING, continued
Financial opening with elastic output
Assume interest rates in the outside
world are closer to 0 than
they were at home.
Shift production
from Period 0 to 1,
and yet consume
more in Period 0,
thanks to foreign
capital flows.
Welfare is higher
at point C.
Capital Flows to Emerging Market Economies: Key Findings
What accounts for the Cautious nature of the increase
Limited
Supply
Capacity
Fear of tighter controls on
Capital Inflows
 Financial Institutions in
deleveraging mode
 Reduction in debt-related
flows
 Moderate FDI flow caused by
anaemic global investment
spending
 Fear of floating and
undue appreciation
Fear of Tightening
Valuation
 Staggering increase in the
Price of market assets
 A moderate increase in net
inflows of portfolio equity
capital
 Limited degree of
economic slack
 Solid Case for CB to
move to a tighter
monetary stance
 Concern to attract
undue short-term capital
inflows
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Enhance growth:
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Reduce volatility
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Augment domestic saving and allow higher investment and
growth
Allow consumption smoothing
Enable portfolio diversification
Improve institutions
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Prevent fiscal profligacy and monetary mismanagement,
enhance rule of law and contract enforcement, improve
policy0making
Do capital inflows help growth?
Period covered is 1970-2000. Source: Prasad, Rajan, and Subramanian (2006)
Capital flows and
financial crises
Source: Laeven and
Valencia, 2008
Source: Kose et al. (2007)
Capital Flows to Emerging Market Economies: The Case For Regulation
Externalities of capital flows:
February 22, 2011
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The welfare theoretic case for regulating capital flows is based on the notion that such flows impose externalities on the recipient countries.
Risky forms of capital inflows create externalities because individual borrowers find it optimal to ignore the effects of their financing
decisions on aggregate financial stability.
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Individual borrowers take the risk of financial crisis in their economy as given and do not recognise that their individual actions contribute to
this risk.
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This prisoners’ dilemma where individual borrowers could not all agree to use less risky financing instruments and less external finance thus
making the economy as a whole more stable, creates a natural role for policy intervention.
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By implication policymakers can make everybody better off (i.e. achieve a Pareto-improvement) by regulating and discouraging the use of
risky forms of external finance, in particular of foreign currency-denominated debts.
Mechanism of financial crises:
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A specific market imperfection that plays a crucial role during emerging market financial crises provides the economic
rational for capital flow regulation:
 International investors typically demand explicit or implicit collateral when providing finance.
 However, the value of most of a country’s collateral depends on exchange rates.
 When an emerging economy is hit by an adverse economic shock, its exchange rate depreciates, the value of its domestic
collateral declines, and international investors become reluctant to roll over their debts.
 The resulting capital outflows depreciate the exchange rate even further and trigger an adverse feedback cycle of declining
collateral values, capital outflows, and falling exchange rates
February 22, 2011
An optimal framework of capital flow regulation
 The level of complexity of capital controls has to be weighed against the
administrative capacity of regulators. If capital flow regulation taxes risky forms of
flows more than safe forms, then it will achieve a shift in the liability structure of
emerging economies towards safer forms of finance. This composition effect would
make the economy more robust to shocks.
 Tax-like measures are likely to be more effective than unremunerated reserve
requirements in the current economic environment. Both forms of capital controls
have been used in practice, and economic theory suggests that the two measures
are largely equivalent since the opportunity cost of not receiving interest on
reserves amounts to a tax.
 Controls on the stock of foreign capital in the country are more desirable than
controls that are solely based on inflows, since potential capital flow reversals
depend on the stock of foreign capital in the country. This can be implemented e.g.
by requiring foreigners to hold their investments in designated “non-resident
investment accounts” and by accruing regulatory taxes on these accounts on a daily
basis.
 Controls should adapt to macroeconomic circumstances. The vulnerability of
emerging economies – and therefore the externalities created by capital inflows –
fluctuates with the domestic business cycle in emerging economies as well as with
global liquidity conditions Just as central bankers adjust interest rates in response
to inflationary pressure, regulators in emerging markets have to regularly adjust
their policy measures to reflect the given macroeconomic environment.
Capital Flows to Emerging Market Economies: Main Intuitions
• It is difficult to argue that investors punish countries when
and only when governments follow bad policies:
 Large inflows often give way suddenly to large outflows, with little
news appearing in between to explain the change in sentiment.
Second, contagion sometimes spreads to where fundamentals are strong.
Recessions hitting emerging markets in such crises have been so big,it is
hard to argue that the system is working well.
• More generally, capital flows have:
often been procyclical, not countercyclical,been the disturbance
source, not the smoother