A Pragmatic Approach to A Pragmatic Approach to Capital ... · Capital Account...
Transcript of A Pragmatic Approach to A Pragmatic Approach to Capital ... · Capital Account...
A Pragmatic Approach to A Pragmatic Approach to Capital Account LiberalizationCapital Account Liberalization
Eswar PrasadCornell University
Presentation partly based on my joint work with:
• Ayhan Kose, Kenneth Rogoff, Shang-Jin Wei (2003, 2006)
• Raghuram Rajan (2005, 2008)
• Raghuram Rajan and Arvind Subramanian (2007)
Benefits of Financial Integration: Theory
Efficient international allocation of capital
Consumption smoothing via international risk sharing
Large welfare effects for developing economies
Figure 4. GDP (per capita, PPP weighted): 1970-2004
100
150
200
250
300
350
1970 1975 1980 1985 1990 1995 2000
Advanced Economies
Emerging Markets
Emerging (excluding China and India)
Other Developing Economies
Figure 5B. Change in Financial Openness and GDP Growth, 1985-2004Unconditional Relationship
FJIZMB
TUN
TGO
TZA
SEN
ZWE
NER
MUS
MWIKEN
GHA
CMR
DZA
THA
PHL
PAK NPL
MYS
KOR
IDNIND
LKA
BGDEGYISRIRN TTO
JAM
VEN
URY
PER
PRY
MEXHND
GTMSLV
ECU
DOMCRI
COL
CHL
BRABOL ARG
ZAF
NZL
AUSTURESP PRT
GRC FINJPNCAN SWE
NOR
ITA DEU FRADNKAUTUSA
-0.02
-0.01
0
0.01
0.02
0.03
0.04
0.05
0.06
-150 -50 50 150 250 350 450
Change in financial openness
Gro
wth
rate
of p
er c
apita
GD
P
Figure 5B. Change in Financial Openness and GDP Growth, 1985-2004Conditional Relationship
USA
AUTDNK FRADEUITA NOR SWECAN
JPN
FINGRCPRTESP
TUR AUS
NZL
ZAFARG
BOLBRA
CHL
COL
CRI DOM
ECU
SLVGTM
HNDMEXPRY
PER
URY
VEN
JAM
TTO
IRN
ISR
EGY
BGDLKA
IND
IDN
KORMYS
NPL
PAK
PHL
THA
DZACMR
GHA
KEN
MWI
MUS
NER
ZWE
SENTZA
TGO
TUN
ZMB
FJI
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
0.04
0.05
0.06
-150 -50 50 150 250 350 450
Change in financial openness
Gro
wth
rate
of p
er c
apita
GD
P
Growth Benefits of Financial Integration: Evidence
About 25 studies of growth effects
No effect: 4Mixed: 18Positive: 3
No robust macroeconomic evidence of growth benefits
Correlation between Growth and Current Account BalancesNon-industrial Countries, 1970-2004
DZA
ARG
BGD
BOL
BRA
CMR
CHL
CHN
COLCRI
CYP
CIV
DOM
ECU
EGY
SLV
ETH
GHA
GTM HTIHND
IND
IDN
IRN
ISR
JAM
JORKEN
KOR
MDG
MWI
MYS
MLI
MUS
MEXMAR
NGA
PAKPAN
PRY
PER
PHLRWA
SEN
SLE
ZAF
LKA
TZA
THA
TTO
TUN
TUR
UGA
URY
VENZMBZWE
-20
24
68
Per
cap
ita G
DP
grow
th
-10 -5 0 5Average current account balance to gdp
Why Doesn’t Foreign Capital Boost Growth?
1. Domestic financial system cannot effectively intermediate foreign capital
Above Median
Below Median
Below Median
Above Median
0.00
1.00
2.00
3.00
Ave
rage
Per
Cap
ita G
DP
Gro
wth
Investment/GDP
Current Account/GDP
Figure 6. Current Accounts, Investment and Growth in Developing Countries
Why Doesn’t Foreign Capital Boost Growth?
2. Foreign capital leads to exchange rate appreciation (overvaluation)
=> Lower exports, returns to investment, and overall growth
Foreign Capital and Overvaluation, 1970-2004
KOR
IRN
BGD
IND
ETHDZAZAF
MUS
GUY
TUR
URY
LKAZWE
ISR
MDG
HTI
MWIKEN
PAKIDN
CMR
SLVRWA
PRY
COL
VEN
SEN
ARG
MAR
BRA
JOR
GHA
PHL
CIV
MLI
GTMECU
UGA
THA
CHLHNDDOMPEREGY
CHN
TZA
JAM
TUN
CRI
MEX
CYP
NGA
SLE
ZMB
TTO
BOLMYS
PAN
-50
050
100
Res
idua
ls o
f ave
rage
ove
rval
uatio
n
-.02 -.01 0 .01 .02 .03Residuals of average net fdi flows to GDP
coef = 837.49992, (robust) se = 363.32526, t = 2.31
Financial Integration and Volatility: Evidence
Capital mobility does not increase probability of crises
Banking crises are most disruptive and occur frequently in closed economies
No evidence that financial integration by itself is proximate determinant of financial crises
But Two Issues on Volatility
Relative volatility of consumption growth increases at low and intermediate levels of integration
Developing economies, including emerging markets, have not attained better risk sharing
Other Ways of Looking at the Data
Effects of different types of private capital flows:
> Equity flows> FDI> Debt
Macroeconomic vs. microeconomic evidence
Summary of New Evidence
Equity market liberalization seems to work
FDI benefits becoming more apparent
Benefits more evident in micro data
More risk-sharing benefits from FDI, portfolio equity flows; debt not good for risk-sharing
The Traditional View
Financial Globalization
More efficient international allocation of capital
Capital deepening
International risk-sharing
GDP growth
Consumption volatility
A Different Perspective
Traditional Channels
Potential Collateral Benefits
Financial market developmentInstitutional development
Better governanceMacroeconomic discipline
Financial Globalization
GDP / TFP Growth
Consumption volatility
FG and Financial Development
Foreign ownership of banks improves efficiency of domestic banking system
Inflows add to depth of equity markets
Financial sector FDI has benefits
Figure 6A. Financial Openness and Financial Development: 1985-2004Private Credit/ GDP
PNG
FJI
ZMB
TUN
TGO
TZA
SENZWE
NER
MUS
MWI
KEN
GHA
CMRDZA
THA
PHLPAK
NPL
MYS
KOR
IDNIND
LKABGD
EGY
ISR
IRN
TTO
JAMVEN
URY
PERPRYMEXHND
GTM
SLV
ECUDOM CRICOL
CHL
BRABOL
ARG
ZAF
NZL
AUS
TUR
ESPPRT
GRC
FIN
JPN
CANSWE
NORITA
DEU
FRA
DNK
AUT
USA
0
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0 50 100 150 200 250 300Mean financial openness
Priv
ate
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dit/
GD
P
Figure 6A. Financial Openness and Financial Development: 1985-2004Stock Market Capitalization/ GDP
USA
AUT
DNKFRA
DEUITA NOR
SWECANJPN
FIN
GRCPRT
ESP
TUR
AUS
NZL
ZAF
ARG
BOL
BRA
CHL
COL CRI ECUSLV
GTMHND
MEX
PRY
PER
URYVEN
JAMTTO
IRN
ISR
EGY
BGDLKA
INDIDN
KOR
MYS
NPLPAK
PHLTHA
GHAKENMWI
MUSZWE
TZATUN ZMBFJI
CHN
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0 50 100 150 200 250 300Mean financial openness
Stoc
k M
arke
t Cap
italiz
atio
n/ G
DP
.
FG and Quality of Institutions, Governance
Openness to foreign capital provides incentives for improving corporate governance
Corruption, lack of transparency discourage FDI, portfolio flows =>incentives for improving public governance
Figure 6B. Financial Openness and Quality of Institutions: 1985-2004Institutional Quality
CHNPNG
FJI
ZMB
TUN
TGO
TZASEN
ZWE
NER
MUS
MWI
KEN
GHA
CMRDZA
THA
PHL
PAKNPL
MYSKOR
IDN
INDLKA
BGD
EGY
ISR
IRN
TTO
JAM
VEN
URY
PER
PRY
MEX
HNDGTM
SLV
ECU
DOM
CRI
COL
CHL
BRABOL
ARG
ZAF
NZLAUS
TUR
ESP PRT
GRC
FIN
JPN
CAN SWENOR
ITA
DEU
FRA
DNKAUT
USA
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0 50 100 150 200 250 300
Mean financial openness
Inst
itutio
nal Q
ualit
y .
Figure 6B. Financial Openness and Quality of Institutions: 1985-2004Control of Corruption
CHN
PNG
FJI
ZMB
TUN
TGOTZA
SEN
ZWE NER
MUS
MWI
KEN
GHA
CMR
DZATHA
PHL
PAK
NPL
MYSKOR
IDN
IND LKA
BGD
EGY
ISR
IRN
TTO
JAM
VEN
URY
PER
PRY
MEX
HNDGTM
SLV
ECU
DOM
CRI
COL
CHL
BRA
BOL
ARG
ZAF
NZL
AUS
TUR
ESP PRT
GRC
FIN
JPN
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NOR
ITA
DEU
FRA
DNK
AUTUSA
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0 50 100 150 200 250 300Mean financial openness
Con
trol o
f Cor
rupt
ion
FG and Macroeconomic Policy Discipline
Capital account liberalization as commitment device
Even Stiglitz is on board!
Sadly, limited evidence
Complication: Threshold Effects
Threshold ConditionsFinancial market development
Institutional Quality, GovernanceMacroeconomic policies
Trade integration
Financial Globalization
GDP / TFP growth
Risks of Crises
GDP / TFP growth
Risks of Crises
Above Thresholds
Below Thresholds
X?
Why Do Thresholds Matter?
Financial Market Development- Allocates financial flows efficiently- Enhances macroeconomic stability
Institutional Quality- Affects the volume and stability of financial flows- Shifts the composition of flows towards FDI and equity
Trade Openness - Makes less vulnerable to sudden stops- Mitigates the adverse effects of financial crises
TENSION !!
Financial integration can catalyze financial development, improve governance, impose discipline on macro policies...
But, in the absence of a basic pre-existing level of these supporting conditions, financial integration can wreak havoc
Collateral Benefits Framework May Help Make Progress
Unified conceptual framework
Country-specific requirements, initial conditions can be taken into account
Selective approach to liberalization based on prioritization of collateral benefits
Can manage risks during transition to thresholds, but can not eliminate them
Has the Benefit-Cost Tradeoff Improved?
Composition of inflows and stocks of external liabilities has become more favorable
International Financial Integration:Distribution of Gross Inflows(% of Total)
Emerging Markets
0
20
40
60
80
100
FDI Equity Debt
80-84 90-94 00-04
Has the Benefit-Cost Tradeoff Improved?
Composition of inflows and stocks of external liabilities has become more favorable
High levels of foreign exchange reserves
Foreign Exchange Reserves Held by Non-industrial Economies(in trillions of US dollars)
0.0
0.5
1.0
1.5
2.0
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1980 1985 1990 1995 2000 2005
All Non-industrial Economies
All Non-industrial Economiesexcluding China
Foreign Exchange Reserves Held by Non-industrial Economies(as percent of nominal GDP)
0
5
10
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30
1980 1985 1990 1995 2000 2005
All Non-industrial Economies
All Non-industrial Economiesexcluding China
Has the Benefit-Cost Tradeoff Improved?
Composition of inflows and stocks of external liabilities has become more favorable
High levels of foreign exchange reserves
Greater exchange rate flexibility, with inflation targeting
Rising trade openness
Trade Openness(the sum of imports and exports as a ratio to GDP, in 2000 constant prices)
Emerging Markets
20
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40
50
60
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100
1980 1985 1990 1995 2000
25th PercentileMedian75th Percentile
Has the Benefit-Cost Tradeoff Improved?
Composition of inflows and stocks of external liabilities has become more favorable
High levels of foreign exchange reserves
Greater exchange rate flexibility, with inflation targeting
Rising trade openness
New players, new instruments have made international financial markets deeper and more efficient
But …
Many developing economies still below threshold levels of financial, institutional development
Still de facto fixed or tightly-managed exchange rates
Real exchange rate appreciations hurts poor and undeveloped economies
Herding behavior of unregulated investors such as hedge funds + risks in system harder to trace
CAL: The Reality on the Ground
• Capital account becoming de facto more open
• De jure controls increasingly ineffective as channels for capital to flow in and out expand
Rising trade flows
Increasing sophistication of international and domestic investors
Other aspects of financial globalization
Implications of Rising Financial Openness
• Controls not very effective, especially beyond short horizons
• Controls on inflows have large distortionary costs
• Government constantly playing catch-up, which makes policy environment unpredictable
• Maintaining de jure controls despite rising de facto openness => economy has to deal with complications of open capital account but doesn’t get full indirect benefits
Dealing with the Reality of CAL• Key problem is mismatch between level of de facto openness and other policy settings
• Synchronize other policies to deal with open capital account:
monetary policy that can respond nimbly to shocks and focus on domestic objectives
well regulated and supervised financial marketsbroadening of financial markets to reduce effects
of capital flow and exchange rate volatilityfiscal disciplinetrade openness
Pragmatic Approach to CAL
• Manage rather than resist CAL (latter futile in any case)
• Opportunistically liberalizing outflows makes sense in present circumstances
• But need to remove fetters on financial markets to promote vehicles for international portfolio diversification
• Increasing de jure openness can generate positive spillovers for financial market development--e.g., removing restrictions on participation of foreign investors in domestic bond markets
• Level of reserves makes CAL safer (but not riskless)
Complications from an Open Capital Account
• Monetary policy has to cope with domestic liquidity consequences of capital inflows
• Exchange rate management harder, both in terms of level and volatility
• Risks to financial system (if underdeveloped and/or weakly supervised) -- inflows could feed into asset price bubbles
• Regulatory and supervisory capacity may not be sufficient to keep up with foreign firms and financial innovations that they introduce (transitional risks)
Implications for Macro Policies
• Policy objective of tightly managed exchange rate could be counterproductive if capital account is de facto open
• Rising sterilization costs make exchange rate objective untenable
• Monetary stability essential to deal with volatile inflows
• Need a new nominal anchor to take place of exchange rate objective and to manage inflation expectations
• Reducing fiscal deficits and level of government debt is key medium-term objective, esp. to support monetary policy
Implications for Financial Market Regulation
• Financial market regulation must adapt to allow broad range of markets (e.g., currency derivatives) to develop and deepen
• This would provide a buffer against external shocks, and take some of the pressure off monetary policy as a short-term stabilization tool
Broader Policy MessagesFinancial integration can support and catalyze other reforms, especially financial development
Best to actively manage the process of capital account liberalization rather than fight the inevitable
Seize windows of opportunity when benefit-risk tradeoff improves; but coast is never completely clear.
Capital account liberalization not an end in itself; needs to be put in the context of a more completepolicy/reform agenda