Download Lecture 1: Managing Capital Flows

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
