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Thorvaldur Gylfason IMF Institute/Center for Excellence in Finance, Slovenia Course on Macroeconomic Management and Financial Sector Issues Ljubljana, Slovenia September 21–29, 2011 1. 2. 3. 4. 5. 6. 7. 8. 9. Costs and benefits Conceptual framework Anatomy of aid flows Aid, exchange rates, and growth History, context, and recent trends Causes and effects of capital flows Financial crises Capital controls Liberalization of capital flows 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 Unrequited transfers from donor to country designed to promote the economic and social development of the recipient Excluding commercial deals and military aid Concessional loans and grants included, by tradition Grant element ≥ 25% Development aid can be Public (ODA) or private Bilateral (from one country to another) or multilateral (from international organizations) Program, project, technical assistance Linked to purchase of goods and services from donor country, or in kind Conditional in nature IMF conditionality, good governance Moral duty Neocolonialism Humanitarian intervention Public good National (e.g., education and health care) International Social justice to promote world unity UN aid commitment of 0.7% of GDP World-wide redistribution Increased inequality word-wide Marshall Plan after World War II 1.5% of US GDP for four years vs. 0.2% today But this Think tank in Nairobi disagrees, see www.irenkenya.com Objectives Individuals in donor countries vs. governments in recipient countries Who should receive the aid? Today’s Aid poor vs. tomorrow’s poor for consumption vs. investment Conflicts Beneficiaries’ needs Donors’ interests Aid is a recent phenomenon Four major periods since 1950 1950s: Fast growth (US, France, UK) 1960s: Stabilization and new donors Japan, Germany, Canada, Australia 1970s: Rapid growth in aid again due to oil shocks, recession, cold war 1980s: Stagnation, aid fatigue, new methods, new thinking Rapid growth of development aid US provided 50% of total ODA To countries ranging from Greece to South Korea along the frontier of the “SinoSoviet bloc” France To former colonies, mainly in West Africa UK provided 30% provided 10% To Commonwealth countries Stabilization of aid from traditional donors and emergence of new donors US contribution decreased considerably after the Kennedy presidency (1961-63) The French contribution decreased starting from the early 1960s New donors included Japan, Germany, Canada, and Australia Rapid growth in aid from industrial countries in response to the needs of developing countries due to Oil shocks Severe drought in Africa The donor governments promised to deliver 0.7% of GNI in ODA at the UN General Assembly in 1970 The deadline for reaching that target was the mid-1970s Stagnation of development assistance Donor fatigue? Private investor fatigue? 23 United States: largest donor in volume, but low in relation to GDP US aid amounts to 0.2% of GDP Japan: second-largest donor in volume Nordic countries, Netherlands Major donors to multilateral programs Sole countries whose assistance accounts for 0.7% of GDP EU: leading multilateral donor Even if targets and agendas have been set, year after year, almost all rich nations have constantly failed to reach their agreed obligations of the 0.7% target Instead of 0.7% of GNI, the amount of aid has been around 0.4% (on average), some $100 billion short Sub-Saharan Africa and Asia have received the most aid, the former a rising amount over time Aid to Sub-Saharan Africa is high in relation to GDP For the 44 countries in the IMF’s Africa Department, net official transfers are as follows: < 5% of GDP: 14 countries 6%-16% of GDP: 24 countries > 20% of GDP: 6 countries The recent increase in aid flows toward developing countries (particularly Africa) poses crucial questions for both recipient countries and donors What is the role of aid? What is the macroeconomic impact of aid? Is the impact of aid necessarily positive, or could aid have adverse consequences? Recall: Influx of aid is just another type of capital inflow Aid fills gap between investment needs and saving and, if well managed, can increase growth Poor countries often have low savings and low export receipts and limited investment capacity and slow growth Aid is intended to free developing nations from poverty traps E.g., capital stock declines if saving does not keep up with depreciation To understand the link between aid and investment, consider Resource Constraint Identity by rearranging the National Income Identity: Y=C+I+G+X–Z I = (Y – T – C) + (T – G) + (Z – X) Sp Sg Sf In words, investment is financed by the sum of private saving, public saving, and foreign saving This is where aid enters the picture Rearrange again: Y+Z=E+X where E is expenditure E=C+I+G Total supply from domestic and foreign sources Y + Z equals total demand E + X Aid increases recipient’s ability to import: Z rises with increased X, incl. TR Poor countries are trapped by poverty Driving forces of growth (saving, technological innovation, accumulation of human capital) are weakened by poverty Countries become stuck in poverty traps Aid enables poor countries to free themselves of poverty by enabling them to cross the necessary thresholds to launch growth through Saving Technology Human capital Is it feasible to lift all above a dollar a day? How much would it cost to eradicate extreme poverty? Let’s do the arithmetic (Sachs) Number of people with less than a dollar a day is 1.1 billion Their average income is 77 cents a day, they need 1.08 dollars (don´t ask) Difference amounts to 31 cents a day, or 113 dollars per year Total cost is 124 billion dollars per year, or 0.6% of GNP in industrial countries Less than they promised! – and didn’t deliver Several empirical studies have assessed the impact of aid on growth, saving, and investment The results are somewhat inconclusive Most studies have shown that aid has no significant statistical impact on growth, saving, or investment However, aid has positive impact on growth when countries pursue “sound policies” Burnside and Dollar (2000) aid has sometimes been compared to natural resource discoveries Aid and growth are inversely related across countries Cause and effect 156 countries, 1960-2000 Per capita growth adjusted for initial income (%) Foreign r = rank correlation r = -0.36 6 4 2 0 -2 -4 -6 -8 -20 0 20 40 60 Foreign aid (% of GDP) 80 No robust relationship between aid and growth Aid works in “countries with good policies” Aid works if measured correctly Distinction between fast impact aid (infrastructure projects) and slow impact aid (education) Infrastructure: High financial returns Education and health: High social returns So, empirical evidence is mixed Need to distinguish between different types of aid Need to acknowledge diminishing returns to aid as well as limits to domestic absorptive capacity Need to clarify interaction with governance and good policies Special case: Post-conflict situations Aid may lead to corruption Aid may be misused, by donors as well as recipients Donors: Excessive administrative costs Recipients: Mismanagement, expropriation Aid may be badly distributed, sometimes for strategic reasons Supporting opposition government against political Aid increases public consumption, not public investment Aid is procyclical When Aid it rains, it pours leads to “Dutch disease” Labor-intensive and export industries contract relative to other industries in countries receiving high aid inflows Dutch disease may undermine external sustainability Aid volatility and unpredictability may undermine economic stability in recipient countries Economic vs. social impact Growth is perhaps not the best yardstick for the usefulness of aid Long run vs. short run E.g., increased saving reduces level of GDP in short run, but increases growth of GDP in long run (Paradox of Thrift) Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness In 1960s, Netherlands discovered natural resources (gas deposits) Currency appreciated Exports of manufactures and services suffered, but not for long Not unlike natural resource discoveries, aid inflows could trigger the Dutch Disease in receiving countries Foreign exchange is converted into local currency and used to buy domestic goods Fixed exchange rate regime Expansion of money supply leads to inflation and an appreciation of the domestic currency in real terms Flexible Increase exchange rate regime in the supply of foreign exchange leads to a nominal appreciation of the currency, so the real exchange rate also appreciates Review theory of Dutch disease in simple demand and supply model Real exchange rate Payments for imports of goods, services, and capital Imports Earnings from exports of goods, services, and capital Exports Foreign exchange Real exchange rate Aid leads to appreciation, and thus reduces exports C B A Imports Exports plus aid Exports Foreign exchange Real exchange rate Oil discovery leads to appreciation, and reduces nonoil exports C B A Imports Exports plus oil Exports Foreign exchange Real exchange rate Composition of exports matters C B A Imports Exports plus oil Exports Foreign exchange A large inflow of foreign aid -- like a natural resource discovery -- can trigger a bout of Dutch disease in countries receiving aid A real appreciation reduces the competitiveness of exports and might thus undermine economic growth Exports have played a pivotal role in the economic development of many countries An accumulation of “know-how” often takes place in the export sector, which may confer positive externalities on the rest of the economy From aid fatigue to new initiatives Aid effectiveness is ambiguous Positive results likely with better policies and governance Five Primary Guidelines Minimize risks of Dutch disease Enhance growth – Always a good idea! Assess the policy mix Promote good governance and reduce corruption Prepare an exit strategy 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. 52 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-supported program 2008-2011 following collapse of banking system Key ingredients Fiscal consolidation Monetary restraint Bank restructuring Capital controls, temporarily Why controls? Without controls, currency would have depreciated by more than 50% … … with unacceptable balance-sheet consequences for households and firms What are the risks? Controls will be in force longer than planned, causing serious distortions (Rolex index) 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, Iceland 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