Capital Flows to Emerging Market Economies

Forecast,Analysis and Policy Recommendations

April 2011

Overview:•Net private capital inflows to emerging economies are estimated to have been $908 billion in 2010, which is 50% higher than in 2009.•Private flows are projected to increase to $960 billion in 2011 and is $1009billion in 2012.•The 2010 estimate is $83 billion greater than in October and $187 billion higher than the projection a year ago.•Rising flows are supported by strong emerging market fundamentals, long-term investor portfolio rebalancing and abundant global liquidity.•Resurgent capital inflows raise important policy questions; most emerging economies need tighter monetary policy but would also benefit from tighter fiscal and macroprudential policies, and allowing more currency appreciation.•For emerging Asia, Inflows this year and next are likely to average around $430 billion, with the region again accounting for more than 40% of ... flows to emerging markets.•Flows of foreign direct investment should exceed $150 billion a year, more than half of which will go to China and $36 billion to India. Foreign purchases of domestic stocks should stabilize at around $120 billion a year, again dominated by China and India.•In the past year, the world has seen another boom, with a tsunami of capital, portfolio equity and fixed-income investments surging into emerging-market countries perceived as having strong macro-economic, policy and financial fundamentals. •Such inflows are driven in part by short-term cyclical factors (interest-rate differentials and a wall of liquidity chasing higher-yielding assets as zero policy rates and more quantitative easing reduce opportunities in the sluggish advanced economies).•Add to the mix of factors behind the inflows are Longer-term secular factors such as emerging markets’ long-term growth differentials relative to advanced economies; investors’ greater willingness to diversify beyond their home markets; and the expectation of long-term nominal and real appreciation of emerging-market currencies.

Capital Flows to Emerging Market EconomiesFebruary 22, 2011

• The IMF has reversed its position and is allowing developing countries under some circumstances to control the free flow of capital to protect their economies.

• This very pragmatic view is a product of a new policy framework outlined by the fund to use policy tools like taxes, interest rates to curb the flows of cash in and out of countries.

• EM should try to deepen their capital markets to help absorb cash inflows and prevent surges from causing damaging distortions in their economies.

• Since that takes time, however, governments should adjust monetary or fiscal policies as the first line of defense, such as by boosting the value of their currencies, buying foreign-exchange reserves, adjusting interest rates and tightening budget.

• The framework also lays the foundations for the Group of 20 industrial and developing nations as they devise a "code of conduct" on capital controls.

• The main concern is that the treatment of capital-flow issues will be based on a biased approach and deficient analysis. The new framework could also be viewed as a tool for the IMF to heighten surveillance of emerging markets.

 

Capital Controls: A reversal of Policy

Capital Flows: Analysis and Empiric International Financial Integration

• Capital Flows to Developing Countries• An international debt cycle.• Reasons for flows to emerging markets in the 1990s & 2000s.

• Pros and Cons of Open Financial Markets

• Advantages• The theory of intertemporal optimization• Other advantages

• Disadvantages of financial integration• Procyclical capital inflows• Periodic crises

February 22, 2011

1st boom 3rd boom2nd boom

start(recycling

petro-dollars)

start

startstop

(international debt crisis)

stop (Asia crisis)

Three booms in capital flows to developing countries

Capital Flows: Dissecting The Causes

Domestic Economic Reforms

External factors

Cross-border factors

Econominc. Liberalization

Privatization Monetary

stabilization Removal of

capital controls

pro-market environment assets for sale higher returns open to inflows

More of Northern portfolios in mutual funds

New vehicles: country funds, ADRs Brady Plan lifted debt overhang of 1980s Moral hazard from earlier bailouts

The third

emerging

market boom began

in 2003.

Between 2003-07, emerging markets used the inflows to build up Forex Reserves rather than to finance Current Account Deficits

Net Capital Flow

Change in Reserves

Current Account Balance

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

% o

f GD

P

in % of GDP(Low- and middle-income countries)

1980-2006

In the early 1990s,

portfolio investmen

t dominated.

This time (2003-07) Foreign Direct

Investment (FDI) was bigger.

Both China and India used reserve accumulation to finance Capital inflows

Latin America ran CA surpluses and added to reserves

Central/Eastern Europe is the one emerging markets group that ran worrisome current account deficits, esp. Hungary, Ukraine, Latvia...

Advantages of financial opening in emerging-market countries

• Investors in richer countries can earn a higher return on their saving by investing in the emerging market than they could domestically

• Everyone benefits from the opportunity to diversify away risks and smooth disturbances

• Letting foreign financial institutions into the country improves the efficiency of domestic financial markets.

• Governments face the discipline of the international capital markets in the event they make policy mistakes

February 22, 2011

Assessing The effects of opening stock Markets to foreign investors

Cost of Equity capital falls.

February 22, 2011

Assessing The effects of opening stock Markets to foreign investors

Rate of capital formation rises

February 22, 2011

=> domestic residents borrow from abroad, so that they can consume more in Period 0.

THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL

BORROWING

THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL BORROWING, continued

Financial opening with elastic output

Assume interest rates in the outsideworld are closer to 0 than

they were at home.

Welfare is higher at point C.

Shift production from Period 0 to 1,and yet consume more in Period 0,thanks to foreigncapital flows.

Capital Flows to Emerging Market Economies: Key Findings

Limited Supply Capacity

Valuation

Financial Institutions in deleveraging mode

Reduction in debt-related flows

Moderate FDI flow caused by anaemic global investment spending

Financial Institutions in deleveraging mode

Reduction in debt-related flows

Moderate FDI flow caused by anaemic global investment spending

Staggering increase in the Price of market assets

A moderate increase in net inflows of portfolio equity capital

Staggering increase in the Price of market assets

A moderate increase in net inflows of portfolio equity capital

Fear of tighter controls on Capital Inflows

Fear of floating and undue appreciation

Fear of floating and undue appreciation

Fear of Tightening

Limited degree of economic slack

Solid Case for CB to move to a tighter monetary stance

Concern to attract undue short-term capital inflows

Limited degree of economic slack

Solid Case for CB to move to a tighter monetary stance

Concern to attract undue short-term capital inflows

What accounts for the Cautious nature of the increase

Enhance growth: Augment domestic saving and allow higher investment and

growth Reduce volatility

Allow consumption smoothing Enable portfolio diversification

Improve institutions Prevent fiscal profligacy and monetary mismanagement,

enhance rule of law and contract enforcement, improve policy0making

Do capital inflows help growth?

Period covered is 1970-2000. Source: Prasad, Rajan, and Subramanian (2006)

Capital flows and financial crises

Source: Laeven and Valencia, 2008

Source: Kose et al. (2007)

February 22, 2011

Capital Flows to Emerging Market Economies: The Case For Regulation

Externalities of capital flows:

•The welfare theoretic case for regulating capital flows is based on the notion that such flows impose externalities on the recipient countries.•Risky forms of capital inflows create externalities because individual borrowers find it optimal to ignore the effects of their financing decisions on aggregate financial stability.•Individual borrowers take the risk of financial crisis in their economy as given and do not recognise that their individual actions contribute to this risk.•This prisoners’ dilemma where individual borrowers could not all agree to use less risky financing instruments and less external finance thus making the economy as a whole more stable, creates a natural role for policy intervention.•By implication policymakers can make everybody better off (i.e. achieve a Pareto-improvement) by regulating and discouraging the use of risky forms of external finance, in particular of foreign currency-denominated debts.Mechanism of financial crises:•A specific market imperfection that plays a crucial role during emerging market financial crises provides the economic rational for capital flow regulation:International investors typically demand explicit or implicit collateral when providing finance.However, the value of most of a country’s collateral depends on exchange rates.When an emerging economy is hit by an adverse economic shock, its exchange rate depreciates, the value of its domestic collateral declines, and international investors become reluctant to roll over their debts.The resulting capital outflows depreciate the exchange rate even further and trigger an adverse feedback cycle of declining collateral values, capital outflows, and falling exchange rates

February 22, 2011

The level of complexity of capital controls has to be weighed against the administrative capacity of regulators. If capital flow regulation taxes risky forms of flows more than safe forms, then it will achieve a shift in the liability structure of emerging economies towards safer forms of finance. This composition effect would make the economy more robust to shocks.

Tax-like measures are likely to be more effective than unremunerated reserve requirements in the current economic environment. Both forms of capital controls have been used in practice, and economic theory suggests that the two measures are largely equivalent since the opportunity cost of not receiving interest on reserves amounts to a tax.

Controls on the stock of foreign capital in the country are more desirable than controls that are solely based on inflows, since potential capital flow reversals depend on the stock of foreign capital in the country. This can be implemented e.g. by requiring foreigners to hold their investments in designated “non-resident investment accounts” and by accruing regulatory taxes on these accounts on a daily basis.

Controls should adapt to macroeconomic circumstances. The vulnerability of emerging economies – and therefore the externalities created by capital inflows – fluctuates with the domestic business cycle in emerging economies as well as with global liquidity conditions Just as central bankers adjust interest rates in response to inflationary pressure, regulators in emerging markets have to regularly adjust their policy measures to reflect the given macroeconomic environment.

 

An optimal framework of capital flow regulation

Capital Flows to Emerging Market Economies: Main Intuitions

• It is difficult to argue that investors punish countries when and only when governments follow bad policies:

Large inflows often give way suddenly to large outflows, with little news appearing in between to explain the change in sentiment.

Second, contagion sometimes spreads to where fundamentals are strong. Recessions hitting emerging markets in such crises have been so big,it is

hard to argue that the system is working well.

• More generally, capital flows have: often been procyclical, not countercyclical,been the disturbance source, not the smoother