Thorvaldur Gylfason From Dependence to Diversification: The Case of Iceland.
Thorvaldur Gylfason IMF Institute/Joint Vienna Institute Course on Macroeconomic Management and...
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Transcript of Thorvaldur Gylfason IMF Institute/Joint Vienna Institute Course on Macroeconomic Management and...
Thorvaldur Gylfason
IMF Institute/Joint Vienna InstituteCourse on Macroeconomic Management
and Natural Resource Management Vienna, 31 January - 11 February 2011
Capital flows and crises1. Costs and benefits2. Conceptual framework3. History4. Recent trends5. Causes and effects6. Crises7. Liberalization8. Capital controls
Definitiono International capital movements refer to
flows of financial claims between lenders flows of financial claims between lenders and borrowersand borrowers
o 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 foro SpecializationSpecialization, like trade in commoditieso Intertemporal trade Intertemporal trade in goods and services
between countrieso International diversification of riskdiversification of risk
Significant benefits, but
there are costs as well
The case for free trade in goods and services applies also to capital
Trade in capital helps countries to specialize according to comparative advantagecomparative advantage, exploit economies of scaleeconomies of scale, and promote competitioncompetitionExporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know-how, technologyBut financial capital is volatilevolatile
The balance of payments R = X – Z + FR = X – Z + Fwhere
RR = change in foreign reservesXX = exports of goods and servicesZZ = imports of goods and servicesFF = FFXX – FFZZ = net exports of capital
Foreign direct investment (net)
Portfolio investment (net)
Foreign borrowing, net of amortization
X includes aid
Facilitate borrowing abroad to smooth consumption over timeDampen business cyclesReduce vulnerability to domestic economic disturbancesIncrease risk-adjusted rates of returnEncourage saving, investment, and economic growth
Sudden inflows of capital, e.g., following capital account liberalization, impact economy like natural resource booms
Currency appreciatesCurrency appreciatesVolatilityVolatilityPublic expenditure expandsPublic expenditure expands
Immunization becomes necessaryImmunization becomes necessaryStabilizationStabilizationCapital controlsCapital controls
Emerging countries
Industrial countries
Saving
Saving
Investment Investment
Real
inte
rest
rate
Real
inte
rest
rate
Borrowing
Lending
Loanable funds Loanable funds
Financial globalization encourages investment in emerging countries and saving in industrial countries
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
Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.
A stylized view of capital mobility 1860-2000
Cap
ital
m
ob
ilit
y
First era of internationa
l financial integration
Capital controls
Return toward
financial integration
-50
50
150
250
350
450
550
0
10
20
30
40
50
60
70
80
Net private capital flows
cumulative share of selected countries as a proportion of total net private capital flows to emerging markets
Source: IMF, World Economic Outlook database.
Source: IMF WEO
-400
-350
-300
-250
-200
-150
-100
-50
0
50
100
150
200
250
300
350
400
450
500
550
600
650
700
Bill
ions
of
USD
($)
-2
-2
-1
-1
0
1
1
2
2
3
3
In P
erce
nt o
f G
DP
(%
)
Direct investment, net (left axis) Other private, net (left axis) Official capital flows, net (left axis)
Direct investment/GDP (right axis) Other private/GDP (right axis) Official capital/GDP (right axis)
Source: IMF WEO
-400
-350
-300
-250
-200
-150
-100
-50
0
50
100
150
200
250
300
350
400
450
500
550
600
650
700
Bill
ions
of
USD
($)
0
25
50
75
100
125
150
175
200
Deb
t R
atio
s in
Per
cent
(%
)
Direct investment, net Other private, net (left axis) Official financial flows, net
Debt/GDP (right axis) Debt/ Exports of G&S (right axis) Debt Service/Exports of G&S (right axis)
Capital flows result from interaction between supply and demandCapital is “pushedpushed” away from investor countries Investors supplysupply capital to recipients
Capital is “pulledpulled” into recipient countriesRecipients demanddemand capital from
investors
Internal factors “pulledpulled” capital into LDCs from industrial countries
Macroeconomic fundamentals in LDCsMore productivity, more growth, less
inflation Structural reforms in LDCs
Liberalization of tradeLiberalization of financial markets Lower barriers to capital flows
Higher ratings from international agencies
External factors “pushedpushed” capital from industrial countries to LDCs
Cyclical conditions in industrial countriesRecessions in early 1990s reduced investment
opportunities at homeDeclining 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
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
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 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)
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
Improved allocation of global savings allows capital to seek highest returnsGreater efficiency of investment More rapid economic growthReduced macroeconomic volatility through risk diversification dampens business cyclesIncome smoothingConsumption smoothing
Open capital accounts may make receiving countries vulnerable to foreign shocks Magnify domestic shocks and lead to
contagionLimit effectiveness of domestic
macroeconomic policy instrumentsCountries with open capital accounts are vulnerable to Shifts in market sentiment Reversals of capital inflowsMay lead to macroeconomic crisisSudden reserve loss, exchange rate pressureExcessive BOP and macroeconomic
adjustmentFinancial crisis
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
Increase in quasi-fiscal deficit Following from sterilization operations by central bank
Expansion in bank lendingTo finance consumption and investment boomsReduced loan qualityIncreased 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
-3 -2 -1 0 1 2 3 4 5 6 70
100
200
300
400
500
600
-200
0
200
400
600
800
1,000
1,200
1,400
1,600
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).
Sweden
Venezuela
Chile 1978-81 Mexico
Chile 1989-94
Finland
Large deficitsCurrent account deficitsGovernment budget deficits
Poor bank regulationGovernment guarantees (implicit or explicit),
moral hazard
Stock and composition of foreign debtRatio of short-term liabilities to foreign
reserves
MismatchesMaturity mismatches (borrow short, lend long)Currency mismatches (borrow in foreign
currency, lend in domestic currency)
Source: Finance and Development, September 1999.
Mexico, '93-95
Korea, '96-97
Mexico, '81-83
Thailand, '96-97
Venezuela, '87-90
Turkey, '93-94
Venezuela, '92-94
Argentina, '88-89
Malaysia, '86-89
Indonesia, '84-85
Argentina, '82-83
0 10 20 30 40 50 60Billion dollars
10% of GDP
12% of GDP
9% of GDP
18% of GDP
15% of GDP
11% of GDP
6% of GDP
10% of GDP
7% of GDP
5% of GDP
4% of GDP
Transitory
High degree of risk sharin
g
Permanent
No risk
sharing
Foreign direct
investment
Long term debt
(bonds)
Portfolio equity
Short term debt
Capital controls aim to reduce risks associated with excessive inflows or outflows
Specific objectives may includeProtecting a fragile banking systemAvoiding 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
Administrative controlsOutright bans, quantitative limits, approval
procedures Market-based controls
Dual or multiple exchange rate systemsExplicit taxation of external financial
transactions Indirect taxation
E.g., unremunerated reserve requirement Distinction between
Controls on inflowsinflows and controls on outflowsoutflowsControls on different categories of capital
inflows
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)
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 differenceStrengthen financial sector and prudential framework before removing capital account restrictionsRemove restrictions on FDI inflows earlyLiberalize outflows after macroeconomic imbalances have been addressed
Pre-conditions for liberalizationSound macroeconomic policiesStrong domestic financial systemStrong and autonomous central bank
Timely, accurate, and comprehensive data disclosure
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 stabilityThese 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 statusMalaysia imposed capital
controls
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 hazardsNeed 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
THE ENDThese slides will be posted on my
website: www.hi.is/~gylfason