Tag Archives: capital flows

Assigned Readings: Dec. 30, 2013

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In the run-up to the financial crisis the world economy was characterized by large and growing current-account imbalances. Since the onset of the crisis, China and the U.S. have rebalanced. As a share of GDP, their current-account imbalances are now less than half their pre-crisis levels. For China, the reduction in its current-account surplus post-crisis suggests a structural change. Panel regressions for a sample of almost 100 countries over the thirty-year period 1983-2013 confirm that the relationship between current-account balances and economic variables such as performance, structure, wealth and the exchange rate changed in important ways after the financial crisis.

I discuss how the unconventional monetary policy measures implemented over the past several years – quantitative and credit easing, and forward guidance – can be analysed in the context of conventional models of asset prices, with particular reference to exchange rates. I then discuss alternative approaches to interpreting the effects of such policies, and review the empirical evidence. Finally, I examine the ramifications for thinking about the impact on exchange rates and asset prices of emerging market economies. I conclude that although the implementation of unconventional monetary policy measures may introduce more volatility into global markets, in general it will support global rebalancing by encouraging the revaluation of emerging market currencies.

We study the long-run relationship between public debt and growth in a large panel of countries. Our analysis takes particular note of theoretical arguments and data considerations in modeling the debt-growth relationship as heterogeneous across countries. We investigate the issue of nonlinearities (debt thresholds) in both the cross-country and within-country dimensions, employing novel methods and diagnostics from the time-series literature adapted for use in the panel. We find some support for a nonlinear relationship between debt and long-run growth across countries, but no evidence for common debt thresholds within countries over time.

  • Atish R. Ghosh, Mahvash S. Qureshi, Juk Il Kim and Juan Zalduendo. “Surges.” Journal of International Economics, forthcoming.

This paper examines when and why capital sometimes surges to emerging market economies (EMEs). Using data on net capital flows for 56 EMEs over 1980−2011, we find that global factors, including US interest rates and investor risk aversion act as “gatekeepers” that determine when surges of capital to EMEs will occur. Whether a particular EME receives a surge, and the magnitude of that surge, however, are largely related to domestic factors such as its external financing need, capital account openness, and exchange rate regime. Differentiating between surges driven by exceptional behavior of asset flows (repatriation of foreign assets by domestic residents) from those driven by exceptional behavior of liability flows (nonresident investments into the country), shows the latter to be relatively more sensitive to global factors and contagion.

In bilateral and multilateral surveillance, countries are often urged to consider alternative policies that would result in superior outcomes for the country itself and, perhaps serendipitously, for the world economy. While it is possible that policy makers in the country do not fully recognize the benefits of proposed alternative policies, it is also possible that the existing policies are the best that they can deliver, given their various constraints, including political. In order for the policy makers to be able and willing to implement the better policies some quid pro quo may be required—such as a favorable policy adjustment in the recipients of the spillovers; identifying such mutually beneficial trades is the essence of international policy coordination. We see four general guideposts in terms of the search for globally desirable solutions. First, all parties need to identify the nature of spillovers from their policies and be open to making adjustments to enhance net positive spillovers in exchange for commensurate benefits from others; but second, with countries transparent about the spillovers as they see them, an honest broker is likely to be needed to scrutinize the different positions, given the inherent biases at the country level. Third, given the need for policy agendas to be multilaterally consistent, special scrutiny is needed when policies exacerbate global imbalances and currency misalignments; and fourth, by the same token, special scrutiny is also needed when one country’s policies has a perceptible adverse impact on financial-stability risks elsewhere.

Be Careful What You Wish For

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Policymakers, including finance ministers and central bank governors, are as entitled to have holiday wishes as much as anyone else. But they should be careful with their wish list. Sometimes the law of unintended consequences leads to unexpected and undesirable side effects.

The expansion of domestic financial markets can promote economic growth through a more efficient allocation of savings and other mechanisms.  Foreign participation in these markets can contribute to their development in several ways. Foreign investors, for example, can provide more liquidity that leads to lower yields. Shanaka Pereis found that a 1% increase in the share of foreign investors in government bond markets in ten emerging markets led to a decrease of about 6 basis points in the yield on those bonds. All this suggests that capital flows benefit financial markets.

But larger financial markets can also bring unanticipated consequences. After Federal Reserve Chair Ben Bernanke spoke last spring of tapering the Fed’s asset purchases, the exchange rates of many emerging markets depreciated while their central banks used their foreign reserves to slow the changes. Barry Eichengreen and Poonam Gupta have investigated these reactions. They find that the magnitude of the changes in exchange rates and reserves were linked to the size and openness of a country’s financial markets. They interpret this as evidence that foreign investors rebalanced their portfolios in those markets with the most largest and liquid financial systems. They conclude that “success at growing the financial sector can be a mixed blessing.” Financial regulators need to be ready for the volatility that increased capital flows can bring along with all their benefits.

Another Divergence

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The decline in inflation rates in advanced economies to historically low rates has been widely reported.  But inflation is increasing in some of the largest emerging markets. This divergence poses dilemmas for policymakers in those countries.

The annual difference between the GDP-weighted average inflation rates of high income countries and developing nations has fluctuated between 3-4% between 2010 and 2012 (see data here). More recently, the gap has jumped to 4.8%. Among the countries where prices are rising more rapidly are Brazil (5.8% in the most recent month), Egypt (10.5%), India (10.1%), Indonesia (8.3%), Russia (6.2%), and South Africa (5.5%).  Moreover, all except Russia are recording current account deficits.

The increase in prices is drawing attention. In Brazil and Indonesia, rising prices are fueling popular discontent with the governments. The Russian central bank has admitted that it will miss its inflation target for the year. Arvind Subramanian finds inflation in India worrisome, in part because it is unprecendently high.

What fuels the rises? In many emerging markets, the governments have sought to offset reduced demand by their trade partners in the advanced economies by stimulating domestic demand. The result has been increases in domestic credit and household debt, and in these countries escalating prices.

Some central bankers have responded by raising their target interest rates. In India, the new target rate is 7.75%. Brazil’s central bank has raised its target rate to 10%, and Indonesian monetary policymakers have hiked their rate to 7.5%. South Africa’s central bank has kept its rate unchanged, but signaled that this may change.

These increases could leave the central bankers in a quandary. After blaming the Federal Reserve for capital flows to their countries, it would be awkward if the same policymakers were now seen as responsible for creating the conditions that could attract capital. Moreover, higher rates might choke off the domestic spending that it is seen as essential. But allowing inflation to continue unchecked could result in harsher measures later. Of course, higher growth in the advanced economies could alleviate many of these problems. Convergence can work in more than one direction.

Assigned Readings: November 14, 2013

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Taking a historical perspective of economic changes, this paper argues that muddling through crises-induced reforms characterizes well the evolutionary process of forming currency unions. The economic distortions facing the euro include structural challenges in the labor and product markets, and financial distortions. While both structural and financial distortions are costly and prevalent, they differ in fundamental ways. Financial distortions are moving at the speed of the Internet, and their welfare costs are determined more by the access to credit lines and leverage, than by the GDP of each country. In contrast, the structural distortions are moving at a slow pace relative to the financial distortions, and their effects are determined by inter-generational dynamics. These considerations suggest that the priority should be given to dealing with the financial distortions. A more perfect Eurozone is not assured without successfully muddling through painful periodic crises.

International financial linkages, particularly through global bank flows, generate important questions about the consequences for economic and financial stability, including the ability of countries to conduct autonomous monetary policy. I address the monetary autonomy issue in the context of the international policy trilemma: countries seek three typically desirable but jointly unattainable objectives: stable exchange rates, free international capital mobility, and monetary policy autonomy oriented toward and effective at achieving domestic goals. I argue that global banking entails some features that are distinct from broad issues of capital market openness captured in existing studies. In principal, if global banks with affiliates established in foreign markets can reduce frictions in international capital flows then the macroeconomic policy trilemma could bind tighter and interest rates will exhibit more co-movement across countries. However, if the information content and stickiness of the claims and services provided are enhanced relative to a benchmark alternative, then global banks can weaken the trilemma rather than enhance it. The result is a prediction of heterogeneous effects on monetary autonomy, tied to the business models of the global banks and whether countries are investment or funding locations for those banks. Empirical tests of the trilemma support this view that global bank effects are heterogeneous, and also that the primary drivers of monetary autonomy are exchange rate regimes.

We analyse global and euro area imbalances by focusing on China and Germany as large surplus and creditor countries. In the 2000s, domestic reforms in both countries expanded the effective labour force, restrained wages, shifted income towards profits and increased corporate saving. As a result, both economies’ current account surpluses widened before the global financial crisis, and that of Germany has proven more persistent as domestic investment has remained subdued.

In contrast to earlier recessions, the monetary regimes of many small economies have not changed in the aftermath of the global financial crisis. This is due in part to the fact that many small economies continue to use hard exchange rate fixes, a reasonably durable regime. However, most of the new stability is due to countries that float with an inflation target. Though a few have left to join the Eurozone, no country has yet abandoned an inflation targeting regime under duress. Inflation targeting now represents a serious alternative to a hard exchange rate fix for small economies seeking monetary stability. Are there important differences between the economic outcomes of the two stable regimes? I examine a panel of annual data from more than 170 countries from 2007 through 2012 and find that the macroeconomic and financial consequences of regime‐choice are surprisingly small. Consistent with the literature, business cycles, capital flows, and other phenomena for hard fixers have been similar to those for inflation targeters during the Global Financial Crisis and its aftermath.

  • Much has been done since 2010 to reduce macroeconomic imbalances in the Euro Area periphery and to bolster economic and financial integration at the EU level
  • Stronger exports may now be stabilizing output after two years of contraction, but headwinds remain with fiscal adjustment continuing and bank lending constrained
  • Market sentiment, underpinned by OMT, has improved with better economic news
  • Challenges remain, however, including the need to restore full bond market access for Portugal as well as Ireland and agree further financing and relief for Greece
  • Italy remains at risk over the longer term, with a return to durable growth requiring deeper structural reforms that political divisions are likely to impede
  • Progress mutualizing sovereign and bank liabilities looks likely to remain limited, leaving Euro Area members vulnerable to renewed weakness in market sentiment

Strategic Retreat or Tactical Pause?

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Several recent analyses of financial globalization offer different perspectives on whether the recent contraction in capital flows represents a cyclical decline or a long-term reversal. On the one hand, the expansion of gross financial flows in the last decade among upper-income countries will not continue at the same pace. But the development of financial markets in emerging markets will increase capital flows within that group of countries as well as draw funds from the advanced economies.

Richard Dobbs and Susan Lund of the McKinsey Global Institute note that cross-border flows are more than 60% below the pre-crisis peak. They attribute the decline to a “dramatic reversal of European financial integration” as European banks curtail their lending activities. They also draw attention to “a retrenchment of global banking” due to a reassessment by banks of their foreign activities in light of new capital requirements and regulations. Dobbs and Lund are concerned that too strong a reversal will result in a segregated global financial system.

Greg Ip of The Economist also writes about a reversal of financial integration for a similar set of reasons. Bankers are shrinking their balance sheets while regulators seek to shield their domestic financial markets from foreign shocks. In addition, Ip draws attention to the renewed interest in the use of capital controls to lower volatility. The IMF now includes controls as a tool that policymakers can use to manage the risks associated with surges of capital flows. But like Dobbs and Lund, Ip is concerned about financial fragmentation, and urges financial regulators to cooperate in order to achieve common standards.

The authors of the World Bank’s Capital for the Future: Saving and Investment in an Interdependent World, on the other hand, draw attention to developing countries and emerging markets as both a source and destination of capital flows. These countries are likely to account for an increasing share of gross capital flows, which will be driven (p. 125)  “…by more rapid economic growth and lower population aging in developing countries than in advanced countries, as well as by developing countries’ relatively greater scope for increasing openness and strengthening financial sector institutions.” They see evidence of this trend prior to the global financial crisis, as the share of gross capital inflows to developing countries rose from 4 percent of the total in 2000 to 11 percent in 2007.

Foreign direct investment accounted for most of these inflows, although bank loans have also increased. While portfolio flows have constituted a relatively small share of inflows to these countries, the authors of Capital for the Future believe that in the future a larger proportion will flow through the capital markets. Ultimately, they claim (p. 131), there will be “developing-country convergence with advanced economies in terms of their composition of their capital inflows.” Policymakers can expedite the transition to more portfolio flows through the development of domestic financial markets and their regulatory structure.

China will play a major role in any increase in capital flows to emerging economies. Foreign exchange reserves have been the traditional form of asset accumulation in that country. Tamim Bayoumi and Franziska Ohnsorge of the IMF use a portfolio allocation model to speculate about the effects of the liberalization of capital regulations by the Chinese authorities on the private sector. They infer from their estimates that (p. 14) “capital account liberalization may be followed by a stock adjustment of Chinese assets abroad on the order of 15-25 percent of GDP and a smaller stock adjustment for foreign assets in China on the order of 2-10 percent of GDP.” The acquisition of foreign stocks and bonds by Chinese investors who would seek to diversify their portfolios could offset any continued increase in FDI inflows. The IMF economists contrast this forecast with one for India, which they believe would have more balanced flows following capital account deregulation because of smaller asset holdings by Indian investors and hence a more restricted scope for diversification.

These scenarios for the future of financial globalization need not contradict each other. On the one hand, bank lending in the U.S. and Europe is likely to be limited as governments enact new regulations and Europe continues to deal with its debt crisis. But investors in those countries may look to the emerging and “frontier” markets for higher returns based on their growth, while increased income in the emerging markets will drive a demand for liquid financial instruments that will spill over into foreign markets. In addition, firms in those countries will look to expand their operations in other developing economies through investments. Financial flows may follow a new course, but will not be contained for long.

Apples and Naranjas

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The Economist has published its indicator of vulnerability to a “capital freeze.” (An earlier version published on September 7 was revised.) The ranking for 26 emerging markets is based on each country’s current account balance as a percent of its GDP, its short-term external debt and debt repayments relative to foreign exchange reserves and sovereign wealth fund assets, the growth rate of credit to the private sector, and the Chinn-Ito index of financial openness. The ten countries rated as most at risk are Turkey, Romania, Poland, Mexico, Colombia, Peru, Argentina, Indonesia and Chile.

Not surprisingly, there has been some pushback from officials of the countries at the top of the rankings. Mauricio Cárdenas, Colombia’s minister of finance, defends his country’s economic reputation in a letter. The minister claims that those who devised the rankings ignored the sources of vulnerability to a sudden stop, including the source of financing for the current account.  Mr. Cárdenas points out that Colombia’s current account is “fully financed by foreign direct investment instead of short-term capital flows.”

Does he have a case? We calculated Colombia’s current account/GDP and FDI/GDP ratios over the last three years (2010-12), and compared them with other Latin American economies on the index:

% Current Account/GDP FDI/GDP
Argentina -0.05 2.34
Brazil -2.24 2.92
Mexico -0.70 1.67
Venezuela 4.28 0.76
Colombia -3.05 3.54

Score one for the minister: the current account deficits of the last three years were indeed offset by inflows of FDI.  Game, set, match for Colombia?

Perhaps not. The size of the current account deficits, one of the components of the capital-freeze index, stands out. More importantly, the minister is mixing flows and stocks. The FDI inflows create FDI liabilities that are not easily reversed. But the country’s short-term external debt is the source of vulnerability to a sudden stop. Nervous lenders can simply cease renewing lines of credit or other credit facilities, and domestic borrowers will be cut off from funding. Reversals of short-term external debt were features of the Mexican, East Asian, Russian and Brazilian crises of the 1990s.

The debt data for the five South American countries in 2011 show why Brazil is rated as less risky than Colombia and the other nations. These countries are more vulnerable to a change in sentiment by foreign lenders. Venezuela does not appear in the top ten on the capital-freexe index in part because it is not as financially open as the others, and thus less exposed.

% External Debt/GNI Short-term Debt/External Debt
Argentina 26.35 14.53
Brazil 16.64 10.42
Mexico 25.20 17.88
Venezuela 21.82 24.56
Colombia 24.31 14.06

Colombia’s finance minister has justification to be proud that his country attracts sufficient FDI to finance its current account deficits. And there is no reason to expect that those flows will cease. But the country’s external debt liabilities, the result of past borrowing, are the source of potential hazard.