Controlled Capital Account LiberalizationControlled Capital Account Liberalization

Eswar Prasad & Raghuram Rajan

IMF

Plan of Talk Plan of Talk Reserve accumulation—how much, why, and cost-Reserve accumulation—how much, why, and cost-

benefit issuesbenefit issues

Approaches to sterilizationApproaches to sterilization

Other approaches to dealing with inflowsOther approaches to dealing with inflows

The Prasad-Rajan proposalThe Prasad-Rajan proposal

The proposal in the broader context of new The proposal in the broader context of new literature on financial globalizationliterature on financial globalization

China and India as illustrationsChina and India as illustrations

China Foreign Exchange Reserves: Flows and Stocks

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5

10

15

20

25

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35

40

Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05

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SD

)

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Monthly changes Stock of reserves (RH)

India Foreign Exchange Reserves: Flows and Stocks

-6

-4

-2

0

2

4

6

8

Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05(in

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Monthly changes Stock of reserves (RH)

Why the Build-up of Reserves?Why the Build-up of Reserves?

Capital flows to emerging marketsCapital flows to emerging markets

Speculative inflowsSpeculative inflows

Current account surplusesCurrent account surpluses

Oil revenuesOil revenues

China: Reserve Accumulation and its Components

-100

-50

0

50

100

150

200

250

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

USD

bill

ion

Reserve accumulation

Current account balance

Net FDI

Net non-FDI capital inflows plus errors and omissions

India: Reserve Accumulation and its Components

-20

-10

0

10

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30

40

2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 2005Q2

USD

bill

ion

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20

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USD

bill

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Reserves(Right axis)

Private capital flows(Left axis)

Current account balance(Left axis)

Benefits of Reserve AccumulationBenefits of Reserve Accumulation

Reduced vulnerability to crisesReduced vulnerability to crises

Mitigates real exchange rate appreciationMitigates real exchange rate appreciation

Lowers external borrowing costsLowers external borrowing costs

Costs of Reserve AccumulationCosts of Reserve Accumulation

Complications for macroeconomic Complications for macroeconomic managementmanagement

Adjustment may come through inflationAdjustment may come through inflation

Opportunity cost of holding reservesOpportunity cost of holding reserves

Quasi-fiscal costs of sterilizationQuasi-fiscal costs of sterilization

Domestic policy distortions Domestic policy distortions

Sterilization: Instruments/MethodsSterilization: Instruments/Methods

Repos, open market operationsRepos, open market operations

Central Bank securitiesCentral Bank securities

Fx swapsFx swaps

Government deposits at the Central BankGovernment deposits at the Central Bank

Reserve requirementsReserve requirements

China: Stocks of Reserves and Central Bank Bills(in billions of RMB)

0

1000

2000

3000

4000

5000

6000

7000

Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05

Foreign Exchange Reserves

Stock of Outstanding PBC Bills

India: Stock of Reserves and Sterilization Instruments

-400

-200

0

200

400

600

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1,000

1,200

Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05

(in

bill

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s of

US

D)

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bill

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s of

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Govt Securities

Repos

MSB

Stock of foreign exchange reserves(RHS)

China: PBC Bill Rates vs. U.S. Treasury Yields

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05

PBC 3-month PBC 1-year U.S. 3-month U.S. 3-year

U.S. rates

PBC rates

India Domestic Bond Yields vs. U.S. Treasury Yields

0.0

1.0

2.0

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Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05

India Govt Securities - 1 year

India Repo Rate

U.S. 3-month

U.S. 3-year

India Rates

U.S. Rates

What Are Countries Doing with Reserves? What Are Countries Doing with Reserves? Actions and ProposalsActions and Proposals

U.S. bonds (Treasury and Agency)U.S. bonds (Treasury and Agency)

Other industrial country treasury paperOther industrial country treasury paper

Bank recapitalization (China)Bank recapitalization (China)

Infrastructure investment (India)Infrastructure investment (India)

Korea Investment CorporationKorea Investment Corporation

Improving Risk-Return Profile of ReservesImproving Risk-Return Profile of Reserves

Diversify into non-U.S. $ denominated Diversify into non-U.S. $ denominated instruments, goldinstruments, gold

Regional pooling of reserves—e.g., Asian Regional pooling of reserves—e.g., Asian Investment Corporation (Genberg et al.)Investment Corporation (Genberg et al.)

Invest reserves in broader range of Invest reserves in broader range of instruments including foreign equitiesinstruments including foreign equities

Asset management by IMF and World Bank Asset management by IMF and World Bank (Summers)(Summers)

Other Policy ActionsOther Policy Actions

Tighter controls on inflowsTighter controls on inflows

Liberalization of outflows:Liberalization of outflows:

• Firms (retain fx earnings, borrow in fx)Firms (retain fx earnings, borrow in fx)

• Households Households

• Institutional investors (QDII)Institutional investors (QDII)

Is There a Way to Do Better?Is There a Way to Do Better?

How to Achieve Multiple Objectives? How to Achieve Multiple Objectives?

• Get benefits of inflows Get benefits of inflows

• Reduce costs of sterilization and fx Reduce costs of sterilization and fx exposure of Central Banksexposure of Central Banks

• Lower risks of capital account liberalizationLower risks of capital account liberalization

The Prasad-Rajan ProposalThe Prasad-Rajan Proposal

Reserves

$

Central

Bank

Inflows

Liquidity

$

RMB

CB Bills

RMB

Central

Bank

Inflows

$

RMB

Liquidity

$

RMB

Closed-end

Mutual Fund

Investments

$

Shares

RMBFinancial Market

DevelopmentSterilization

Controlled Outflows:

Quantity + Timing

International Portfolio Diversification

Other BenefitsOther Benefits

Provides breathing room for some Provides breathing room for some macroeconomic reforms (fx flexibility)macroeconomic reforms (fx flexibility)

Fx risk taken off Central Bank’s balance sheetFx risk taken off Central Bank’s balance sheet

Securitizing inflows may facilitate reduction in Securitizing inflows may facilitate reduction in external borrowing costsexternal borrowing costs

Could complement other approaches such as Could complement other approaches such as QDII QDII

Potential ConcernsPotential Concerns

Could delay more fundamental reformsCould delay more fundamental reforms

Governance problemsGovernance problems

Multiple exchange ratesMultiple exchange rates

Rents to mutual funds if excess demand for Rents to mutual funds if excess demand for securitiessecurities

Fx risk transferred to householdsFx risk transferred to households

No demand for securities if expectation of No demand for securities if expectation of currency appreciation currency appreciation

The Macroeconomic Implications Of The Macroeconomic Implications Of Financial Globalization:Financial Globalization:

A Reappraisal And SynthesisA Reappraisal And Synthesis

Ayhan Kose, Eswar Prasad, Kenneth Rogoff, Shang-Jin Wei

The Proposal in a Broader Context

Financial Globalization

More efficient international allocation of capital

Capital deepening

The Traditional View

International risk sharing

GDP growth

Csmn. volatility

Financial Globalization

Financial market developmentInstitutions, governanceMacroeconomic disciplineCompetition

A Different Perspective

Collateral Benefits

GDP growth

Csmn. volatility

Factors that Influence Outcomes of Factors that Influence Outcomes of Financial Integration: Threshold EffectsFinancial Integration: Threshold Effects

Financial Sector DevelopmentFinancial Sector Development

Institutions, GovernanceInstitutions, Governance

Macro Policies Macro Policies

Trade Openness Trade Openness

Exchange Rate Regime Exchange Rate Regime

TENSION !!TENSION !!

Financial integration helps developing Financial integration helps developing countries to improve their financial countries to improve their financial markets, enhance governance, impose markets, enhance governance, impose discipline on macro policies, break power discipline on macro policies, break power of interest groups that block reforms, etc.of interest groups that block reforms, etc.

But, in the absence of a basic pre-existing But, in the absence of a basic pre-existing level of these supporting conditions, level of these supporting conditions, financial integration can wreak havocfinancial integration can wreak havoc

What’s a Country to Do?What’s a Country to Do?

Trade integration to begin with; but often Trade integration to begin with; but often results in de facto financial integration. results in de facto financial integration. Works okay, but not ideal substitute Works okay, but not ideal substitute

Collateral benefits perspective can guide Collateral benefits perspective can guide country-specific sequencing of capital country-specific sequencing of capital account opening account opening

Controlled capital account liberalization if Controlled capital account liberalization if experiencing inflows, external circumstances experiencing inflows, external circumstances favorablefavorable