Capital Account Liberalization and Crises

1. Capital Account Liberalization and Crises Thorvaldur Gylfason IMF Institute/Joint Vienna Institute Course on Macroeconomic Management and Natural Resource Management Vienna, 31 January - 11 February 2011

2. Outline Capital flows and crises • Costs and benefits • Conceptual framework • History • Recent trends • Causes and effects • Crises • Liberalization • Capital controls

3. 1 Capital flows: costs and benefits • Definition • 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 • Intertemporaltrade in goods and services between countries • International diversification of risk Significant benefits, but there are costs as well

4. Goods and Capital • The case for free trade in goods and services applies also to capital • Trade in capital helps countries to specialize according to comparative advantage, exploiteconomies of scale, and promote competition • Exporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know-how, technology • But financial capital is volatile

5. Symmetry between Goods and Capital The balance of payments R = X – Z + F where DR= 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 X includes aid

6. Capital flows: for what? • 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

7. Capital inflows resemble natural resource booms • 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

8. 2 Capital flows: conceptual framework Emerging countries save a little Saving Real interest rate Investment Loanable funds

9. Capital flows: conceptual framework Industrial countries save a lot Real interest rate Saving Investment Loanable funds

10. Capital flows: conceptual framework Emerging countries Industrial countries Financial globalization encourages investment in emerging countries and saving in industrial countries Saving Lending Real interest rate Real interest rate Saving Borrowing Investment Investment Loanable funds Loanable funds

11. 3 Relevance and Context • 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

12. Evolution of capital flows A stylized view of capital mobility 1860-2000 Return toward financial integration First era of international financial integration Capital mobility Capital controls Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.

13. Net private Capital flows to emerging markets, 1980-2007 Source: IMF WEO, Oct. 2007, Chapter 3, Figure 3.1. 4

14. Concentration of Net Private Capital Flows to Selected Countries, 1990-2007 Source: IMF, World Economic Outlook database.

15. Total capital inflows (USD, billions)

16. emerging markets: Net Private Capital Flows, 1980-2009 Source: IMF WEO

17. all emerging and developing countries: Net Capital Flows and external debt indicators, 1980-2009 Source: IMF WEO

18. Mirror image

19. 5 Causes of capital inflows:Push vs. pull factors 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

20. Causes of capital inflows:Push vs. pull factors 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

21. Causes of capital inflows:Push vs. pull factors 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

22. Push factors • 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

23. Push factors • 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)

24. pull factors • Structural changes in emerging markets • Better financial market infrastructure • Improved corporate and financial sector governance • More liberal regulations regarding foreign portfolio inflows • Stronger macroeconomic fundamentals • Solid current account positions (except in emerging European countries) • Improved debt management • Large accumulation of reserve assets

25. effects of capital inflows:potential benefits • 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

26. effects of capital inflows:potential risks • 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

27. effects of capital inflows:potential risks • 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

28. Episodes of Large Net Private Capital Inflows: Number, Size, and Ending Source: IMF WEO, Oct. 2007, Chapter 3, Table 3.1.

29. effects of capital inflows:potential risks 6 • 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

30. Real stock prices during inflow periods, selected countries Chile 1978-81 Mexico Venezuela Chile 1989-94 Sweden Finland 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).

31. Early warning signs 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)

32. Ratio of short-term liabilities to foreign reserves in asia 1997 Guidotti-Greenspanrule

33. Iceland: Central bank foreign exchange reserves 1989-2008 (% of foreign liabilities of banking system at end of year)

34. Large reversals

35. Some types of capital flows are riskier than others Portfolio equity High degree of risk sharing Foreign direct investment Short term debt Long term debt (bonds) No risk sharing Transitory Permanent

36. 7 Role of capital controls  • 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

37. Types of Capital Controls • Administrative controls • 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 between • Controls on inflows and controls on outflows • Controls on different categories of capital inflows

38. Imf annual report on exchange arrangements and exchange restrictions • 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)

39. Country experiences with capital account liberalization 8 • 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

40. Sequencing Capital Account Liberalization Pre-conditions for liberalization • Sound macroeconomic policies • Strong domestic financial system • Strong and autonomous central bank • Timely, accurate, and comprehensive data disclosure

41. Financial crises in 1990s called capital liberalization in doubt • 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 middle-income status Malaysia imposed capital controls

44. These slides will be posted on my website: www.hi.is/~gylfason conclusion THE END • 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