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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.

In and Out

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Two recent IMF publications offer different perspectives on how policymakers should handle capital outflows. One outlines a tactical response to an unplanned reversal, while the second provides a strategy to prepare for volatility before it occurs.

The first approach appears in an IMF Policy Paper, Global Impact and Challenges of Unconventional Monetary Policies. Most of the paper deals with the effects of unconventional monetary policies (UMP) designed to restore the operations of financial markets and/or to support economic activity when the central bank’s policy rate has hit the lower bound. The measures include the purchase of bonds not usually bought by a central bank and forward guidance on interest rates. The paper draws upon the experiences of the Bank of England, the Bank of Japan, the European Central Bank, and the Federal Reserve.

The paper also deals with the possible challenges posed by the eventual winding down of the UMP both within the countries that have implemented them and in non-UMP countries. The authors of the report warn that ”In non-UMP countries, currencies will depreciate (to balance changes in relative bond returns) and bond yields might rise…” They further caution that “Some capital flow reversal and higher borrowing costs are to be expected, but further volatility could emerge, even if exit is well managed by UMP countries.” The report points to one source of volatility: “Further amplification could come from the financial system, where stability could be undermined as non-performing loans rise, capital buffers shrink, and funding evaporates.”

What can the non-UMP policymakers do to offset or least minimize this turbulence? Relatively little, according to the report. Central banks should maintain their credibility through appropriate monetary policies (always a good idea), allow some change in their exchange rates (but avoid disorderly adjustment!), and reverse measures that were implemented during periods of capital inflows (but only if this does not endanger financial stability!). The IMF offers to coordinate national policies to curtail negative spillovers, and promises to provide credit as needed. The IMF’s message for the non-UMP countries, therefore, seems to be: A storm is coming! It might be bad! Close the windows and doors, and place your faith in a higher power (conveniently located at 700 19th Street in Washington, DC)!

A different message comes from the authors of Chapter 4 of the IMF’s latest World Economic Outlook, entitled “The Yin and Yang of Capital Flow Management: Balancing Capital Inflows with Capital Outflows.”  Its authors make the distinction between those emerging market countries that respond to capital inflows through a current account deterioration (a “real” adjustment) versus those with offsetting capital outflows (“financial” adjustment). They find that the latter group registered a smaller response to the 2008-09 global financial crisis, as manifested in changes in GDP, consumption and unemployment. The former group includes Argentina, India and Turkey, while the latter group includes Brazil, Mexico and Thailand. The authors attribute the better experience of those countries that experienced “financial adjustment” to several factors, including the repatriation by their residents of their foreign assets to smooth consumption in the face of a shock.

Of course, the withdrawal of assets from foreign countries is feasible only if those assets are relatively liquid. Evidence on this aspect of the financial crisis comes from Philip Lane in his authoritative account of the role of financial globalization in precipitating and propagating the global crisis, “Financial Globalisation and the Crisis,” which appeared in Open Economies Review  (requires subscription). He reports that emerging economies were “long debt, short equity” in the period preceding the crisis. Their assets consisted of liquid foreign debt that they could draw upon if needed, while their liabilities were in the form of FDI and portfolio equity. The advanced economies, on the other hand, followed the opposite strategy of “long equity, short debt,” which was profitable but hazardous once the crisis hit.

There is another way, however, to evaluate the strategy of “financial adjustment.” Countries that match inflows with outflows have less exposure on a net basis, and net exposure may be tied to the occurrence of an external crisis. A recent IMF working paper by Luis A. V. Catão and Gian Maria Milesi-Ferretti, “External Liabilities and Crises,” reports that the risk of a crisis increases when net foreign liabilities rise above 50% of GDP and the NFL/GDP ratio rises 20% above a country’s historic mean. Moreover, when they examine exposure on different classes of liabilities, they find that the increase in crisis risk is linked to net debt liabilities.

Financial adjustment, therefore, was a successful strategy for minimizing the capital flow volatility for several reasons. The emerging market countries that implemented it lowered their international financial exposure and issued risk-sharing equity rather than debt. They were therefore less vulnerable than those countries with more liabilities that included relatively more debt. Given the cyclical nature of capital flows, such prophylactic measures should be enacted before the next storm arrives.