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 save a little

Saving

Investment

Real

inte

rest

rate

Loanable funds

Industrial countries save a lot

Saving

Investment

Real

inte

rest

rate

Loanable funds

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

16

Sourc

e:

IMF

WEO

, O

ct.

200

7,

Chapte

r 3

, Fi

gure

3.1

.

-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

Source: IMF WEO, Oct. 2007, Chapter 3, Table 3.1.

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)

Guidotti-Greenspan rule

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