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Thorvaldur Gylfason IMF INSTITUTE Course on Natural Resources, Finance, and Development Stellenbosch, South Africa November 15-26, 2010 Capital flows and crises 1. 2. 3. 4. 5. 6. 7. 8. Costs and benefits Conceptual framework History Recent trends Causes and effects Crises Liberalization Capital controls 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 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. 16 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) Source: IMF WEO 300 40 275 250 30 Billions of USD ($) 200 20 175 150 10 125 100 0 75 50 -10 25 09 08 20 07 20 20 06 20 05 20 04 20 03 20 02 01 20 00 20 99 20 98 19 97 19 96 19 95 19 94 19 93 19 92 19 91 19 90 19 89 19 88 19 87 19 86 19 85 19 84 19 83 19 82 19 19 19 19 81 0 80 -20 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) Source: IMF WEO Debt Ratios in Percent (%) 225 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 (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 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